Stock Options Basics – How It Works,Types And Benefits

Stock Options Basics - How It Works,Types And Benefits

Have you ever wondered what exactly is a stock option?

Well, let’s start with a short description and example:

What Is A Stock Option?

A stock option is an agreement between two parties – a holder (buyer) and a seller (writer). The buyer purchases the right (but not the obligation) to buy or sell stocks at a predetermined price for an agreed upon period of time.

Why stock options?

Stock options are derivatives which means that their price derives from a security, called underlying stock. Companies and investors use them because of two main reasons – to hedge and speculate. Speculators like buying options because they offer a chance of much higher returns than the ones coming from the security they derive from.

The underlying assets could be stocks, stock indexes, commodities, precious metals, foreign exchange, and others.

Example:

For instance, a buyer purchases a stock option on shares of company A with a strike price of $15. The expiration date is 24 July. This means that you can, but it’s not your obligation, buy Company A shares at $15 a share before or on 24 July.

In the article, you will find more details about the different types of options, their advantages, and other helpful information.

Types of Options: Puts and Calls

Options have two different types: puts and calls.

Call options are contracts which guarantee the right of a holder to purchase stocks at a specific price and by a specific date. If the stock does not meet the price before the contract expires, the holder is not obligated to buy the stocks.

Put options give the holder the right to sell stocks at a predetermined price and a by a specific date. The seller must, by contract, buy the stocks at the agreed-upon price.

What Is The Idea?

If an investor buys a call, it means they believe that the price of the underlying stock will go up. On the contrary, the seller of a call expects the price will go in the opposite direction. If the price does really increase, the holder of the call will buy stocks at a lower price than their current one on.

Sometimes investors think that the prices of a stock will decline, therefore they purchase puts. Assuming the price goes down, the seller must buy the stocks at a lower price than their current market value.

As we already mentioned, there are two main components in each contract: a fixed price and a fixed date (period of time). In stock options, the strike price is the predetermined value at which an option holder can buy or sell stocks.

Leverage And Risk In Options

In business, leverage is an investment strategy in which people use debt to acquire company’s assets.

How does it work?

For example:

If you want to buy 1,000 shares of a company and one share’s price is $15, you have to give $15,000 to acquire them. However, if you purchase an option for the same number of shares but at a price $2, you can see that you’ll have to pay on $15,000.

Therefore, for this $15,000 you can buy three options each giving you 1,000 shares. You will end up in control of more than 7,500 shares for the same amount of $15,000.

Now, there are 2 scenarios:

  1. Company share price increase to 20$

On the first option, you now have 1,000 shares with a total amount of $20,000. Total profit: $5,000

On the second option: you now have 7,500 shares with a total amount of $150,000. Since you have already paid

$15,000 to buy the options + $112,500 to buy the stocks (7,500 shares in $15 each). Total profit: $22,500

      2. Company share price decrease to 10$

On the first option, you now have 1,000 shares with a total amount of $10,000. Total loss: $5,000

On the second option: In this case, you won’t use the option, means you won’t buy the shares, since the current price (10$)  is lower than the option you have to buy them in (15$). Total loss: $15,000 (the amount you paid for the option)

Remember:

Always consider the risk. And even though options have many benefits, there are some drawbacks.  If the price does not reach the strike price within the agreed-upon period, then the holder can lose his initial investment.

Benefits Of Investing In Options

Below I will be looking at some of the main reasons why you should consider investing in options in detail. The three most notable are – hedging, speculation and spreading.

Hedging

Hedging as a business term is a type of investment strategy which tries to mitigate the potential risks a company can encounter. Even you, without knowing, are hedging – for example, you insure your house in order to minimize the risk in case of a fire or an earthquake.

Risk management is a crucial part of any business so it’s only logical that they have a whole strategy regarding this.

The Way it works

Many people claim that you need to use hedging (“insuring” yourself) then options are not a good investment. However, especially if we talk about large businesses, risk management is paramount. The safer you are, the better. That concerns individual investors, too.

Let’s explain:

Usually, they don’t have the financial resources large corporations have, therefore options are very suitable. At the same time, investors want to take advantage of a very attractive stock and protect themselves from potential losses. Therefore, the buy options – low-cost and easy investment that offers risk protection.

Short sellers also use options to hedge while short selling. This is a process in which someone sells an asset he does not own or has borrowed.

It’s easy, isn’t it?

Speculation

Initially, options were not intended for speculation. However, throughout the years, many speculators have started using the niche.

What is speculation?

When investors bet on future prices of, for example a stock, then they speculate. Often they do not have any data or research proving that this price movement might happen. It’s just what they feel or want to happen. The purpose is clear – to make a short-term profit.

Leverage

In this regard, options are very suitable for speculators since, as we discussed, they provide leverage. Traders see them as potentially lucrative because a call option can cost a few times less than a share’s price. This, on the other hand, is what increases the risk in trading options.

Don’t forget:

In an option, you have to preliminary define the number of shares, their price movement and the specific period, which is very similar to gambling. If you fail only with one the components, then your option will expire leading to no results whatsoever.

Spreading

This is yet another advantage of investing in options. It is a strategy that combines both hedging (limiting the risk) and also speculation.

When you spread options it means that you trade with more than one – two, three, etc. Spread options’ value comes from the difference between two or more assets.

Styles of Options

There are different styles of options; the main are:

American-style options

They give the holder of the option the right to purchase the stock before the expiration date. Equity options are this style.

European-style options

This type gives the owner of the option the right to buy the stock only a short period of time before the contract expires. Foreign currency and stock index options are this styles. Despite these options being limited, the holder can sell them anytime.

Capped-style options

There are options with an established cap price. The cap price exists to limit the potential profit for the option owner and mitigates possible losses for the writer. The owner of such a contract has the right to buy the stock only for a specific period of time before the expiry date. If the cap price is reached prior to that, the option is exercised automatically.

Standardized options

Each of this contract is for 100 shares of the underlying stock. These options are traded on most US exchanges unlike some of the other options (employee stock options).

Plain vanilla options

Standard puts and calls with no specific characteristics. If options have some unusual features, then we call them exotic options. For example, they are different than American- or European-style options because of the underlying assets. Also, the time when the option holders receives a payoff. Unlike plain vanilla options, exotic ones are not that easy to trade with.

Binary options

For example, are also known as all-or-nothing options. Why? The payoff is either fixed if the asset reaches the strike price within the fixed period or nothing at all.

Options Expiration

Even though the expiry date is individual for each option contract, it is always on a Saturday. If we have to be more specific, this is the Saturday which follows the third Friday of the last month.

Keep in mind 

Option holders should exercise their right before the Saturday since exchanges do not operate on weekends. Brokers prepare all the documents related to the end of the contract on the next Saturday.

Exchanges For Options

Some options, called listed options, are traded on registered exchanges. For example, Euronext, Boston Options Exchange and International Securities Exchanges. It’s typical for all listed options to have a strike price and expiry date. The underlying stock can be – market indexes, stocks, commodities, ETFs.

People can buy and sell the so-called over-the-counter options too. These are not traded directly on formal exchanges but rather between the counterparties.

Here, it’s good to mention two terms and explain why they matter. Market makers are broker-dealer companies which make sure there is enough liquidity of a stock in the market. The Nasdaq is an example of a market maker.

Bottom Line

Now that you have read the article, you know some of the basics about options – how they work, reasons to invest and types and styles of options. They are cost-effective and flexible investments with a potential for high return. On the other hand, options are very time sensitive and speculative. Each investor should determine whether they are right for them or not.

 

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Jack Wickens

Experienced investor for more than 20 years. Deals mainly with stocks, forex and alternative investments. Writing for my pleasure, always happy to share and get new opportunities. Twitter: https://twitter.com/jackwickens1309

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