Stock Options: What They Are, How They Work

A stock option is an equity contract involving two parties - a buyer and a seller. The buyer of a stock option has the right to either buy or sell the stock of the underlying option at a predetermined price before the options contract expires.

The seller of an options contract has an obligation to either buy or sell the stock of the underlying option if the option is exercised against them. When a buyer purchases a stock option from a seller, they pay the seller a premium to reserve the right to exercise the option before expiration if they choose to do so.

If the option is not exercised, the seller of the option gets to keep the buyers premium as a profit. The buyer of the option loses their premium, but their loss is limited to that premium amount. Stock options are an inherently risky investment, but there are two main types that we will look at below.

Call options give the buyer the right to buy the stock of the contract at the strike price if the contract is executed before it expires. When investors buy call options, they are hoping that the price of the stock of the option will go up.

For example, say that an investor bought an options contract for Company ABC with a strike price of $50. The strike price is simply the price that the investor can purchase the stock at regardless of what the current market price is.

Say that a few months go by and the market price of Company ABC is now trading at $65. The investor who bought call options decides to execute his option. The seller of the options contract is obligated to sell the buyer of the options contract Company ABC stock at $50 per share even though the market price is $65.

The investor who bought the call options gets to buy Company ABC at $50 per share through the options contract and can then go and sell that stock at the current market price of $65. This spread creates the profit for the buyer of the options contract minus the premium they paid for the contract.

Put options on the other hand give the buyer the right to sell the underlying stock of the contract at the strike price. The sellers of put options have an obligation to buy the underlying stock if the contract is exercised against them.

Puts are the opposite of calls in that the investor wants the underlying stock to go down in value. For example, if an investor bought a put option with a $50 strike price, they would want the underlying stock to go below $50.

The premium is the amount of money that the buyer of an options contract pays to the seller of an options contract to reserve the right to buy or sell the security of the option. Remember, when you purchase an options contract, you are not buying the stock itself.

You are simply buying the right to do something. In order to have this right, you pay a premium to the seller. If the buyer of an options contract executes a profitable options contract, their profit will be reduced by the amount of premium that they paid when they bought the contract.

If an option is not executed, the seller of the contract gets to keep the premium as a profit. The premium is calculated by taking the price of the option and multiplying it per contract which is typically 100. If an investor bought one options contract for $2 per contract, they would pay a $200 premium ($2 x 100).

The expiration date of an options contract is simply when the contract expires. If the options contract is not executed before the expiration date, the seller gets to keep the premium and the buyer will not make a profit and locks in the loss of the premium.

The further away the expiration date, the higher the premium for the option tends to be. There are two different types of option styles that play into expiration dates. The first is the American style. An American style options contract can be executed at any point between the purchase date and expiration date.

If you bought a 90 day options contract, you could execute it from now until it expires in 90 days under the American style. European options contracts on the other hand can only be executed on the expiration date itself.

Options contracts are typically sold in lots of 100. This means that one option contract would give the buyer of the contract the right to buy or sell 100 shares of the underlying stock of the contract. Therefore, if you were to buy 5 options contracts, you are reserving the right to buy or sell 500 shares of the underlying stock.

The strike price of an options contract is simply the price at which the contract can be exercised. For example, if an investor bought a call option with a $50 strike price and the market price of the stock rose to $65, the buyer of the contract could execute the option and the seller would have to sell the stock to the buyer at the $50 strike price even though the market price was at $65.

A call option is said to be in the money when the market price of the underlying stock price is higher than the strike price of the option. A put option is said to be in the money when the underlying stock price is lower than the strike price of the option.

Buyers of options contracts will typically only execute an options contract when it is in the money. To be clear, an options contract can be in the money and not profitable. For example, say an investor bought a call option with a $50 strike price.

Say that the current market price of the stock is $52. This options contract is in the money by $2. However, remember that you have to pay a premium when you are the buyer. If the premium for this contract was $2, this option would be at a breakeven point even though it is in the money.

A call option is said to be out of the money when the market price of the underlying stock is lower than the strike price. A put option is said to be out of the money when the market price of the underlying stock is higher than the strike price.

If an option remains out of the money for the duration of the contract until expiration, the buyer of the option will not execute the contract as they will not make any money. The seller of the option wants this to happen as they will get to keep the premium as their profit since the option will not be executed against them.

John is an investor who is looking at investing in Company A (fictional company for sake of example). He believes that the stock price may rise during the next quarter, but does not want to buy the stock itself. He simply wants the option to buy the stock if the price rises.

The current price of the stock is sitting at $48 per share. John buys 1 call option (a lot of 100 shares) with a strike price of $50 for a premium of $4 that expires in 90 days. John pays the seller of the call option a $400 premium ($4 premium x 100 shares) to reserve the right to buy the stock at the strike price.

Say that John ends up being right and the stock price rises to $60 two months after he bought the option. Since the option has not expired, John decides to execute the option. He gets to buy the sock at his strike price of $50 and can then resell the stock at the current market price of $60.

After doing this, John will be left with a profit of $600. This is found by taking the difference between the strike price ($50) and market price ($60 and multiplying that number by the option lot amount of 100 shares giving him $1,000. However, you also need to subtract the $400 premium John paid for the option leaving him with a profit of $600.

Say that John is now looking at investing in Company B. He believes that the stock price of this company will go down over the next quarter for a variety of reasons. He does not want to own a stock that he believes will go down in value, but he does want to capitalize on the opportunity.

For this reason, John decides to buy put options. The current stock price of Company B is $52. John decides to buy 1 put option (lot of 100 shares) with a strike price of $50 for a premium of $3 per share that expires in 90 days.

John ends up being right about Company B as the stock goes down to $43 per share over the next month. John decides to execute his option leaving him with a profit of $400. This is found by taking the difference between the strike price ($50) and the market price ($43) and multiplying it by the lot of 100 shares. The premium of $300 that John paid is then subtracted from this $700 leaving him with $400.

Like most financial questions, the answer is that it depends. What you decide to invest in comes down to your individual risk tolerance and goals. Some investors are going to take a more conservative approach, some a moderate approach, and some an aggressive approach.

Investing in options tends to go beyond the aggressive approach and into the speculative approach. Even if you have good reason to believe that a stock will move up or down and want to capitalize on this price movement, it is not a guarantee that you will be correct.

If you do decide to invest in options, it is arguably less risky to be the buyer of an options contract than it is to be the seller of an options contract. The reason for this is that the most amount of money you can lose when you buy an options contract is the premium you paid.

However, when you sell or write the options contract, the potential for financial loss can be much greater. The point here is simply that investing in options is risky. You need to understand what you are doing and be able to handle the risks associated with options.

More experienced investors may use options to increase their returns or protect other positions that they have, but for the everyday investor options are likely to cause more harm than good. Options should not be viewed as "easy money."

The bottom line is that when you buy stock options you have the right to either buy or sell stock at a predetermined price regardless of the current market price. If you sell or write options, you have an obligation to buy or sell the underlying stock if the option is exercised against you.

Stock options may be a viable investment for experienced and knowledgeable investors who are looking to protect positions they have in their portfolio or increase returns, but for most investors stock options are likely too risky.