Investor’s Manual: What Are Options?

Options are contracts that give the owner (holder) the right to buy or sell an underlying asset, like a stock, at a certain price (the strike or exercise price) before a certain day (the expiration date). A standard contract is 100 shares and the purchase price of the option is referred to as the premium. 

Options are typically used to speculate on the direction of a security or index, hedge against market downturns, or pursue an additional income goal. This is why many active traders add them to their arsenals. 

There are two types of options: call options and put options. Each has its benefits and risks, and these change depending on if you’re the buyer or seller of a call or put option. Let’s start with calls.

Call Options

A call option gives the owner the right, but not the obligation, to buy shares of stock or another underlying asset at the strike price of the option within a specific time period. The seller of the call is obligated to deliver, or sell, the underlying stock at the strike price if the owner of the call exercises the option.

So how does a call option work? Let’s say XYZ stock is trading around $20. You’re very bullish on XYZ so you buy one XYZ call with a strike price of $22 expiring in January 2019. The options premium for the contract is $1. Your maximum loss is the amount you pay for the contract, $100 ($1 options premium x 100 shares), and your maximum gain is unlimited because there is no cap on how much the stock price could increase, not accounting for transaction costs. The break-even point is $23, not including transaction costs ($22 strike price + $1 option premium paid), so you’re hoping that the price of XYZ’s stock rises above $23 before or on the expiration date.

Put Options

A put option gives the owner the right, but not the obligation, to sell shares of stock or another underlying asset at the strike price of the option within a specific time period. The put seller is obligated to purchase the underlying at the strike price if the owner of the put exercises the option.

So how does a put option work? Let’s say ABC stock is trading around $20, but you think the company’s sales are going to decline, causing the stock to fall to $10. You buy one XYZ put with a strike price of $20 expiring in January 2019. The options premium is $2. Your maximum loss is $200 ($2 options premium x 100 shares) and your maximum gain is $1800 ($20 strike price - $2 options premium x 100 shares) if the stock goes to $0, not accounting for transaction costs. The break-even point is $18, not including transaction costs ($20 strike price - $2 option premium), so you’re hoping that the price of XYZ stock falls below $18 before or on the expiration date.

Time to Hit the Market?

Learn more about the basics of options by watching this video.