Options – Understanding the Basics
An option is a contract that gives the holder the right, but not the obligation, to buy or sell a specific security at a predetermined price on a specific date.
Investors buy and sell options just like stocks. There are two basic types of options:
Call Option
A call option is the right to purchase the underlying security at a specific price on a specific date.
You would buy a call option if you expect the price of the underlying security to rise before the option expires. For example:
Company XYZ is trading at $25 per share, and you believe the stock will rise. You could buy shares of the company, or you could buy a call option. You can buy a call option that gives you the right, but not the obligation, to purchase 100 shares of XYZ at any time during the next 90 days at a price of $26 per share for $100.
If you are correct, and the stock price rises to $30 per share before the option expires, you can exercise your option and buy 100 shares at $26 per share and sell them for an immediate profit of $3 per share ($30 – $26 = $4 – $1 for the option = $3 profit per share).
You can also trade the option for a profit without buying the company’s shares.
If you were wrong and the stock price didn’t move or fell from the original $26 per share to $24 per share, you would let the option expire and incur a loss of $100 (the cost of the option).
Put Option
A put option is the right to sell the underlying security at a specific price on a specific date.
You would buy a put option if you believe the stock price will fall before the option expires.
For example, if you believe the stock price will drop from $25 per share, the only way to profit would be to short sell the stock, which could be a risky step if you are wrong.
You can buy a put option at $24 per share for $100 (or $1 per share), which gives you the right to sell 100 shares of XYZ at $24 per share.
If the stock price falls to $19 per share, you could, theoretically, buy 100 shares in the open market at $19 per share, then exercise the put option which gives you the right to sell the stock for $24 per share – netting a profit of $5 per share, minus the cost of the option.
In practice, you would trade your put option, which would now be worth around $5 per share or $500.
Key Facts About Options
Here are some quick facts about options:
– Options are quoted on a per-share basis but are sold only in quantities of 100 shares. For example, a call option may be priced at $2, but you would pay $200 because options are always sold in blocks of 100 shares.
– The strike price (or exercise price) is the price at which the underlying security can be bought or sold according to the terms of the option contract. Options are specified by the month they expire, whether they are a call or put option, and the strike price. For example, “XYZ April 25 Call” is a call option on XYZ stock with a strike price of 25 that expires in April.
– The expiration date is the month that the option expires. Generally, all options expire on the Saturday following the third Friday of the month unless specified otherwise in the contract.
– There are two types of options contracts. American options can be exercised at any time before the expiration date, while European options can only be exercised on the expiration date.
Conclusion
This quick overview of options gives you an idea of what they are, but it represents just a small fraction of the knowledge surrounding them. Options are not for beginner investors but offer advanced traders another tool in their investment arsenal.
Note:
All quotes about options in this article are for illustration purposes only. Pricing options is a complex process that involves many factors.
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Sources:
– U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options.”
Source: https://www.thebalancemoney.com/options-understanding-the-basics-3140542
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