What Are Options?
When used carefully, options are a tool that can help you manage risk, generate income and speculate about the future direction of markets. While they may seem obscure or hard to parse at first glance, once you grasp a few basic concepts, understanding options isn’t too challenging.
What Are Options?
Options are a type of derivative, which means they derive their value from an underlying asset. This underlying asset can be a stock, a commodity, a currency or a bond. To help you understand the basics, we’ll stick to explaining options for stocks.
An option is a contract to exchange an asset like a share of stock at an agreed-upon price in the future. There are always two parties to an options contract: One party creates the option—traders would say they “write” the contract—while the other side buys the option.
- The party who writes the contract is obliged to buy or sell the underlying stock, if necessary.
- The party who buys the contract gets the option to execute the contract in the future, but they have no obligation to complete the trade.
Call Options and Put Options
The world of options is divided between call options and put options, also known as calls and puts.
- Call options. Calls give the purchaser of the option the right (but not the obligation) to buy stock from the writer of the option in the future.
- Put options. Puts give the purchaser the right (but not the obligation) to sell stock to the creator of the options contract at a set price in the future.
Premium, Strike Price and Expiration Date
All options contracts are sold for a fee called a premium. The contract defines a specific price for the trade, called the strike price, and a deadline for the exchange to take place. This deadline, or expiration date, is the final moment the options contract may be executed. Typical options contracts are good for 30, 60 or 90 days, but some can have expiration dates of up to a year.
The further out the options contract’s expiration date, the higher the premium will be. That’s because a longer expiration period provides a greater possibility that the underlying share price might move in the right direction to make the contract buyer a profit.
How to Make Money with Options
The strike price is key to understanding how options make money. Depending on whether the price of the underlying asset rises above or falls below the strike price, the parties to the contract are said to be in the money for a profitable trade or out of the money for a losing trade.
- In the money. For the buyer of an options contract, calls are profitable when the price of the underlying stock is higher than the strike price. Put options are profitable for the buyer when the stock price falls below the strike price.
- Out of the money. For the buyer of an options contract, calls are unprofitable when the strike price is higher than the stock price. Put options are unprofitable for the buyer when the stock price exceeds the strike price.
- At the money. This is when the underlying stock price is the same as the strike price.
So here’s how you make money with options: When a call is in the money, the buyer of the contract has the right to exercise the option and purchase the underlying stock from the writer at a price that’s lower than it is on the stock market. They’ve paid a small fee—the premium—for the right to buy stock at a discount.
When a put is in the money, the buyer of the contract can exercise the option, obliging the writer to buy stock at a price that is higher than the current market price of the shares. Once again, the buyer paid a modest premium for the right to sell stock for a higher price than its currently worth on the market.
What about the option writer? They make money when the options contract is out of the money for the buyer at expiration. Think of it this way: The party buying the contract has the right but not the obligation to follow through with the deal, and if a put or call is out of the money, they don’t exercise the option. This leaves the writer in possession of the premium, which is their profit on the trade.
How to Lose Money with Options
When options contracts—puts or calls—reach their expiration date out of the money, they become worthless. The buyer loses the premium they paid for the option. With puts, they can’t sell stock at a value that’s greater than the market price to the writer of the option, and with calls they don’t get to buy shares at a discount.
Options trading is a highly speculative exercise. That’s because options are often used as a form of leverage, giving traders the ability to buy more stock with less money and greatly magnify their returns. This also means they can lose their entire investment and greatly magnify their losses, too.
While the options buyer only forfeits the premium, the writer faces the possibility of much bigger losses. Take calls: The buyer is in the money when the stock’s price exceeds the strike price—but there’s no limit to how high stock prices can rise, and therefore no limit to the loss incurred by the option writer. With puts, of course, the stock can only go to zero.
Options Buyers and Sellers
Buyer and sellers have competing interests when it comes to options. One side believes the price of the underlying asset will rise over time while the other is betting the price will decline. One side profits when the other party is wrong.
Take puts: The buyer hopes the price of the underlying stock falls so they can sell it to the option writer at a higher price. The writer, meanwhile, wants to see the stock’s price rise so the contract expires worthless, leaving them to pocket the premium.
Options traders typically wear both hats, selling options contracts and purchasing them, depending on market conditions.
- Traders buy call options when they believe the price of the underlying stock will rise, and they sell calls when they believe the price of the stock will fall.
- Traders buy put options when they feel the price of the underlying stock will decrease, and they sell puts when they feel the price of a stock will rise.
Using Options to Hedge Risk
One of the main reasons to trade options is to hedge—or manage—risk. Investors who own positions in stocks may purchase put options to protect against losses. Recall that puts give the buyer the right to sell the underlying shares at the specified strike price on or before expiration, so they rise in value if the underlying stock price declines because their owner can now sell stock that’s declining in value at a markup.
Take an investor who expects a potential market correction to force the value of their stock down 10% or more. They buy puts, which become more valuable when stock values fall, meaning if the stock does fall 10%, the value of the put option would rise by at least 10%. This helps the investor to avoid losing money.
Call Option Example
Company ABC is currently trading at $10 a share, and you believe it’s going higher. Since call options are a bet that the price of the underlying asset will rise, you purchase calls on ABC with a strike price of $12 and an expiration date in one month. The premium is $1, charged per share—options are typically bought in groups of 100—so the total cost to you would be $100.
If the price of ABC were to double after 30 day to $20 a share, you would exercise your option to buy 100 shares of ABC for $12 a share, for $1,200. Together with the premium, your all-in cost is $1,300—but you can turn around and sell the shares on the market for $2,000, netting you $700.
If ABC’s stock price remains $10 or declines, you’d let the contract expire worthless, and your maximum loss would be the $100 you spent on the premium.
The example also illustrates how leverage works in options trading: You’re able to spend only $100 to get control of 100 shares of ABC. At the market price of $10 a share, it would cost $1,000 to buy 100 shares of ABC outright. And your total potential loss is limited to only $100.