What are stock options, and how do they work?
What are stock options, and how do they work?.
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Options can be confusing, complex, and risky. Still, they're popular among investors who understand their mechanics. Why? Because options can produce gains and income. They're also widely used to protect against losses in a portfolio.
Stock options are legal contracts that grant the right to buy or sell a security, like a stock or ETF, at a specific price before a certain date. The contract specifies:
The price at which the shares can be transacted, called the strike price or exercise price
Whether the option is American or European, which affects exercise timing (American options can be exercised anytime before expiration, and European options can only be exercised at expiration)
There are two parties to an options contract: a buyer and a seller. The buyer, known as the option holder, purchases the contract by paying a nonrefundable premium to the seller, who is called the option writer. The rights and obligations of option holders and writers differ based on the type of contract. The two main types are calls and puts.
A call option holder can buy the security from the writer at the strike price before the contract expires.
If the holder exercises the option before expiration, the writer must sell the security to the holder at the strike price.
A put option holder can sell the security to the writer at the strike price before the contract expires.
If the holder exercises the put option before expiration, the writer must buy the security from the holder at the strike price.
Holders don't have to exercise their options. For example, the holder of a call option wouldn't proceed with the transaction if the market price of the stock is less than the strike price. In that case, the better strategy is to do nothing and let the option expire. Alternatively, the holder can sell the option to a third party before expiration.
Option writers have fewer choices. If the holder exercises the option, the writer must fulfill the transaction.
Note that writers can sell covered or uncovered positions. Covered options are backed by owned shares or cash collateral, depending on the contract type. Uncovered, or naked, options are not backed and have much higher risk potential.
To buy or sell an option, you should have a strong opinion about a stock price's future. Let's use Apple ( AAPL ) as an example. Suppose the current share price is $340 and you predict it will rise to $360 in the next month. You could act on that prediction by purchasing a call to buy 100 shares at $350 each.
A reasonable premium might be $5 per share or $500 for 100 shares. Once the premium is paid, three things could happen:
The stock price could rise above the strike price , which puts the contract "in the money" for the holder. An in-the-money contract is valuable, because it grants the right to buy the stock for less than market value. The holder can sell the contract for a gain or exercise the options and purchase the stock to hold or resell.
The stock price could rise to the strike price . At this point, the contract is "at the money."
The stock price could remain below the strike price. The term for this is "out of the money."
