Stock Options: What They Are & How They Work
- What Are Stock Options?
- How Do Stock Options Work?
- Risk Structures of Options vs. Stocks
- Understanding Market Values of Options
- Types of Stock Options
- Benefits of Trading Options
- Risks & Downsides of Buying Options
- Benefit of Writing (Selling) Options
- Taxation of Stock Options
- Is Options Trading Right For You?
Options provide a different kind of opportunity than trading stocks directly. An option gives an investor the right to buy or sell a stock at a future date and at a predetermined price.
What Are Stock Options?
Options give investors the option, or the right, to buy or sell a stock at a particular price and by a certain date, but they do not obligate investors to execute the contract.
Trading stocks involves actually buying or selling a company's stock, based on your forecast for whether the stock is likely to rise or fall. A stock holding generally continues indefinitely. For stock options trading, investors will typically forecast where a stock will trade by a certain point in the future, and then decide whether to take out an options contract if they think the opportunity looks appealing. That options contract will expire at a specific date, making it a finite opportunity.
How Do Stock Options Work?
There are two main types of options, which are calls and puts.
- Call option: gives you the right to buy a stock at a particular price by a certain date
- Put option: gives you the right to sell a stock at a particular price by a certain date. The price that is set is called the strike price.
The person who buys options are called holders (or owners), while those who sell them are referred to as writers. Holders do not have an obligation to execute the contract, but writers are required to buy or sell the stock if the option they wrote is exercised against them. This usually occurs when an option trades "in the money."
A call option is in the money if the market price is higher than the strike price. The strike price is the price at which the writer agreed to buy or sell the stock. A put option is in the money if the market price is below the strike price.
Tip: The two main types of options are calls and puts. Calls give the right (but not the obligation) to buy a stock at a certain price by a certain date, while Puts give the holder the right (but not the obligation) to sell a stock at a certain price by a certain date.
Key Options Terms
- Option holder/owner: The party that holds the option to take a prescribed action
- Option seller/writer: The party that has issued the option, and who must satisfy the other side of the prescribed action should the option be exercised against them
- Call Option Contract: An option to buy a specific security at a stated strike price up until a specified expiry date
- Put Option Contract: An option to sell a specific stock at a stated strike price up until a specified expiry date
- Contract Size: 1 option contract allows the holder to exercise their rights on 100 shares of an underlying stock
- Strike Price: The contracted stock price at which an options holder can buy or sell a stock (until the expiry date)
- Option Premium: The price paid (per share) to own the option contract
- Expiry Date: The date by which the option contract must be exercised - otherwise it expires worthless
- Intrinsic Value: The value of the options contract if it were exercised today (for call options this equals the current stock price less the strike price)
- Time Value: The difference between the current trading value of the option contract & the intrinsic value
Transacting In or Buying Options
You can buy options using some online brokerages like Robinhood, although not all brokerages offer options trading. For example, eToro does not currently offer options trading. Options are sold on exchanges like the Chicago Board of Options Exchange [CBOE], the world's largest options exchange. You can buy options on stocks, exchange-traded funds (ETFs), indexes like the S&P 500, and other investment securities.
One important thing to keep in mind when trading options is that the probability of future events and time until expiration play important roles in choosing strike prices and expiration dates. When you buy options, you must think about the likelihood of different events that will affect the stock price. If you expect a negative catalyst within a foreseeable timeframe, you might want to buy a put option instead of shorting the stock. If you expect a positive catalyst, you might want to buy a call option instead of purchasing the stock.
Risk Structures of Options vs. Stocks
When weighing whether to invest via options or stocks, investors should take into consideration the different risk structures of each. For example, to gain exposure to 100 shares of a stock trading at $50, an investor would have to put $5,000 at risk. If that stock price later dropped to $0, the investor would have lost the entire $5,000. By contrast, it may have been possible to gain exposure to 100 shares of that same stock by purchasing 1 call option (equal to 100 shares) contract at an option premium of $5 (costing $5 x 100 = $500). In such case, the most the options investor could lose is $500.
This doesn't mean that options are less risky than stocks. Options do usually require a lower investment, so an investor would be putting less capital at risk. However, the risk of loss from options contracts are usually higher.
- Current Stock Price: $45/share
- Call Option Premium: $5/share
- Call Option Strike Price: $50/share
- Stock Price at Expiry Date: $51/share
An investor who bought 100 shares of stock would have paid an initial amount of $4,500 ($45 x 100). The stock price reached $51/share, for a total value of $5,100, earning the shareholder $600 profit ($5,100 - $4,500).
The options investor meanwhile would have initially paid $500 ($5 x $100). At expiry, the option would have been worth $100 (($51 - $50) x 100 shares). After deducting the initial cost of the option, the investor would have lost $400 (-$500 + $100) on this endeavor.
So while the stock shareholder would have made a profit, the options investor would have suffered a loss, even though they were both gaining exposure to 100 shares of the same stock.
- Current Stock Price: $45/share
- Call Option Premium: $5/share
- Call Option Strike Price: $50/share
- Stock Price at Expiry Date: $67.50/share
In this scenario, an investor owning 100 shares of the stock would have still invested $4,500, and at an ending share price of $67.50, the position would have been worth $6,750, for a gain of $2,250. Against the invested capital of $4,500, the stock investor would have made a 50% return.
The options investor would have paid $500 for the call options on this stock. Based on a $67.50 price at expiry, the option would have been worth $1,750 ($67.50 - $50, multiplied by 100 shares). Subtracting the option cost of $500, the profit would be $1,250. Against the invested capital of $500, the option investor would have made a 250% return.
Essentially, the ownership of options provides additional leverage on invested capital as compared to owning stocks directly.
Risk of Buying Put Options
A put option works the opposite of a call option, with the value of the contract rising as the price of the stock falls. Buying put options provides a way to place a bet that a stock will decline in value without actually Shorting the shares ("going Short"). Once again, the potential loss on a put option is limited to the premium paid, which means it is a way to bet against a stock while putting a lower amount of capital at risk. However, any potential profit is capped (for both put options and Shorting) because the price of the stock can't fall below $0.
Understanding Market Values of Options
At expiry date, the value of a call option is equal to the stock price less the exercise price. So if a stock is trading at $62/share, a call option to buy shares at a strike price of $60/share would be worth $2/share, at expiry.
If the stock is trading at $62/share one month before expiry, will the $60 call option still be worth $2/share? No, actually the option would be worth more. The key to understanding this is the time value of money.
The time value of money represents the value assigned to the probability that a stock will change in value by the expiry date. To best explain this, consider a call option to buy shares at a strike price of $60/share, when shares of the stock are trading at exactly $60/share. If this is at the time of expiry, the call option will have no value. But if the option hasn't expired yet, investors will still assign some value to the call option, on the possibility that the stock could move above $60/share before the expiry date arrives. That value would represent the time value of money.
- Call Option Strike Price: $50/share
- Current Stock Price: $55/share
- Call Option Premium (=market value): $6/share
In the above example, the intrinsic value of the call option is $5/share ($55 - $50). However, the market value of the call option of $6/share. This suggests that the market is affording an extra value of $1/share to the call option, beyond the intrinsic value. That $1/share of value represents the time value of money.
Types of Stock Options
There are different rules for different types of options:
- American options: enables investors to exercise those option rights at any time before and on the day of expiration. Is the most common and is what most are referring to when speaking about options.
- European options: only allow the contract to be executed on at the time of expiry.
- Asian options: the payoff on the contract depends on the average price of the stock, ETF, or index over a certain period of time.
Benefits of Trading Options
- Potential for leveraged profits: investing in options offers the potential for leverage profits for the buyer, or an income supplement for the option writer (via the Option Premium).
- Speculate without committing: Options enable investors to speculate on price movements in a stock, ETF or index without actually taking a position in them. When an investor buys options, they aren't obligated to complete the contract if it doesn't pan out, but could earn substantial gains if it does.
- Opportunity to hedge a position: Hedging involves opening up a position that will limit your losses if the trade doesn't go the way you expect it to.
For example, an investor could purchase shares of a company and then concurrently buy some put options on the same stock. The put options provide the right to sell shares at a guaranteed price before the contract expires. This can limit the amount of money the investor loses on the share ownership if the stock price declines.
Tip: Some investors buy options to limit their potential losses or speculate on stock price movements.
Risks & Downsides of Buying Options
As with all investing, trading options comes with risks. While investors can limit their downside by buying puts, selling options can open them up to unlimited losses. Just as the gains from buying options can be amplified compared to buying stocks outright, the losses from selling options can be amplified.
Other Downsides of Buying Options
- Limited amount of time for an investment thesis to play out. If the stock doesn't do what was expected before a particular date, then the option may expire worthless, causing the buyer to lose the premium that was paid for it. On the other hand, investors can buy and hold a stock for as long as they want to capture any upside that may be coming down the pike.
- Options traders could incur costs that impact their profit and loss. For example, if an investor sells call options on a stock that they don't already own, they will have to set up a margin account, which is a line of credit that acts as collateral. Another cost to keep in mind is commission fees for dealing in options.
- Different minimum requirements for opening margin accounts. Interest rates on margin loans can range from the low single digits to the low double digits. If your brokerage account balance falls under a minimum level, which can happen due to daily fluctuations of the market, the lender can issue a margin call, and may liquidate your account if you don't add more stock or cash to it.
Benefit of Writing (Selling) Options
While buying options offers the potential for leveraged profits, the only benefit of selling options is the Option Premium that is collected from the buyer. Option writers are often betting that the option won't be exercised against them, allowing them to keep the money they received from writing the option.
Covered Call Writing
One popular strategy is Covered Call writing. This is where an investor owns a certain stock, and then also writes call options on the same stock. If the call option is not exercised against them, they keep the Option Premium. On the other hand, if the stock rises above the exercise price of the option, the option writer may suffer losses. However, those losses will be offset (fully or partially) by the rise of the stock shares that they own. Another way to look at this is that the call option writer owns the stock, and has given the call owner the right to buy that same stock at a certain price. If the stock rises above the strike price, and the call owner exercises their option to buy, the call owner essentially sells the shares of stock they already owns to the option owner at the strike price.
Taxation of Stock Options
Taxation of stock options is quite complex. If you buy a call or put, and the position is closed before the contract expires, the option's holding period determines if it's taxed at short- or long-term capital tax rates. If the purchased call or put option expires, the amount of time you held the option determines if the capital loss is long- or short-term.
If you buy a call option and exercise it, the cost basis of the stock is increased. In this event, there is no tax charged until the stock is sold. The amount of time you hold the stock determines if the capital gain or loss is long or short term. If you exercise a bought put option, the amount realized from the sale of the stock is reduced by the cost of the put.
On the other hand, if you sell a call or put option and the position is closed before it expires, the capital gain or loss is always considered short term. If you sell a call or put and the option expires, you report the amount received for writing the option as a short-term capital gain.
If you sell a call and the option is exercised, the amount you received for writing it increases the amount you received from selling the stock. The amount of time you held the stock dictates whether it's a short- or long-term capital gain. If you sell a put and the option is exercised, you buy the stock, and the cost basis of the stock is decreased by the amount you received for writing the option. The holding period for owning the stock begins the day you buy it.
Is Options Trading Right For You?
The first thing an investor should think about before deciding if options trading is right for them is whether they meet the requirements to be able to trade options. Before beginning, investors must apply with their broker for approval.
The broker will ask a series of questions about one's experience with investing and to determine whether the investor understands the risks inherent in trading options. The broker will then assign a trading level that stipulates the types of options trades an investor can place. All options traders must keep at least $2,000 in their brokerage account.
Also, before trading options, investors should have an understanding of potential catalysts for the stock, ETF or index on which the options are available. Due to the existence of expiry dates on options, investors should develop a short-term thesis for the underlying security. Options are thus more complicated than a buy-and-hold strategy for stocks.
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