Key Takeaways
- Right to buy or sell stock at set price.
- Buyer risks premium; seller assumes obligation.
- Call options profit if stock price rises.
- Put options profit if stock price falls.
What is Stock Option?
A stock option is a derivative contract that grants you the right, but not the obligation, to buy or sell an underlying stock at a set strike price before a specified expiration date. These contracts typically cover 100 shares and are widely used for speculation, hedging, or income strategies.
Options come in two main types: calls, which give the right to buy, and puts, which give the right to sell. Understanding these fundamentals is key to mastering options trading.
Key Characteristics
Stock options have several defining features that influence their value and use:
- Strike Price: The predetermined price at which you can buy (call) or sell (put) the stock.
- Expiration Date: The last date the option can be exercised, affecting time value and premium.
- Premium: The cost to purchase an option, influenced by volatility, time, and underlying stock price.
- Call and Put Types: Call options let you buy stock, while puts let you sell it.
- Leverage: Options allow control of stock positions with less capital than buying shares outright.
How It Works
When you buy a call option, you gain the right to purchase the underlying stock at the strike price before expiration, profiting if the stock price rises above the strike plus the premium paid. Conversely, buying a put option lets you sell stock at the strike price, benefiting if the stock falls below that level.
Sellers of options receive the premium upfront but assume the obligation to fulfill the contract if exercised, which can expose them to significant risk—especially when selling a naked call without owning the underlying shares. Early exercise of options is possible but depends on factors like dividends and time remaining, as explained in the early exercise concept.
Examples and Use Cases
Stock options serve various roles across industries and strategies:
- Airlines: Companies like Delta use options for hedging fuel costs or managing stock-based employee compensation.
- Index Exposure: Options on ETFs such as SPY offer flexible ways to speculate on or hedge against market movements.
- Income Generation: Investors might sell covered calls on stocks they own or utilize options strategies involving Visa shares to collect premiums.
Important Considerations
Be mindful that options involve complex risks, including potential loss of the entire premium for buyers and unlimited losses for sellers of certain contracts like naked puts. Understanding the mechanics of option pricing, time decay, and volatility is crucial before trading.
Choosing a reliable platform is essential; consider using best online brokers to access competitive pricing and educational resources that can help you manage option strategies effectively.
Final Words
Stock options offer flexible strategies for managing risk or seeking leveraged gains, but they require careful attention to strike prices, expiration dates, and premiums. Review your investment goals and run scenarios to determine which option type aligns best with your risk tolerance and market outlook.
Frequently Asked Questions
A stock option is a contract that gives the buyer the right, but not the obligation, to buy or sell a stock at a set price before the contract expires. It typically covers 100 shares and involves paying a premium for this right.
There are two main types: call options, which give the right to buy stock, and put options, which give the right to sell stock. Calls profit when the stock price rises, while puts profit when the stock price falls.
The strike price is the predetermined price at which the buyer can buy (call) or sell (put) the stock if they exercise the option. Whether an option is profitable depends on the stock price relative to this strike price.
An option is in-the-money if exercising it would lead to a profit (e.g., call options when stock price is above strike). Out-of-the-money options would not be profitable if exercised, like a call option with a stock price below the strike.
Buyers risk only the premium paid for the option, limiting their loss. Sellers receive the premium but can face unlimited losses, especially when selling call options if the stock price rises significantly.
The premium depends on the stock’s current price, the strike price, time until expiration, stock price volatility, and interest rates. Higher volatility and longer time to expiration usually increase the premium.
If you buy a call option with a strike price of $170 for a $5 premium and the stock rises to $180, you can buy at $170 and sell at $180, making a $10 profit per share minus the $5 premium, resulting in a net gain.
The expiration date is the last day the option can be exercised. Options can expire weekly, monthly, or quarterly, and after this date, the option becomes worthless if not exercised.
