If you follow financial news, you’ve probably heard of options before, even if you don’t completely know what they are.
Options are a type of derivative that investors can use to execute complex trading strategies or to leverage their portfolios. Unlike stocks or bonds, which have an inherent value because they represent ownership of a company or debt, options derive their value from other securities.
What Are Options?
An option is an agreement between two people to conduct a specific transaction. One party writes the option and sells it to the other party, who buys it and becomes the option holder.
The holder of the option contract has the power to exercise the contract, which means the transaction described in the contract happens. The option holder can also choose not to exercise the contract, in which case no transaction occurs after the sale of the option.
The party buying the option pays a premium to the party that writes the option.
There are three elements to all options, regardless of their type:
- An underlying security
- A strike price
- An expiration date
Each option contract describes a transaction that could occur in the future. The first element the contract specifies is what security will be involved. For example, two people could agree to an option contract involving Coca-Cola stock.
A typical contract involves 100 shares of whatever underlying security is involved.
The next element specified in the option is the strike price. This is the price at which the transaction will occur if the option holder exercises the option. For example, the option might specify that the transaction for 100 shares of Coca-Cola will occur at $50 per share.
Finally, options have expiration dates. Once someone buys an option, they may exercise the option at any time up to its expiration date. After the option expires, the option holder can no longer exercise the option to make the transaction occur.
It’s important to remember that the holder of an option has the right but not the obligation to exercise the option. If the transaction specified in the contract wouldn’t be profitable for the option holder, they generally will not exercise the option. If the transaction would produce a profit, they will likely choose to exercise it.
In general, the option seller profits if the holder chooses not to exercise the option because the option writer gets to pocket the premium they received when selling the option.
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Call options are one of the two main types of options. A call option gives the holder of the option the right but not the obligation to purchase the underlying shares at the specified price.
For example, someone might buy a call option to buy 100 shares of Disney stock at $140 each with an expiration date of October 31. To buy the option, that person has to pay a premium to the option writer.
If Disney stock rises above $140 per share between the time the person buys the option and the expiration date, they can exercise the option to buy 100 shares at $140, no matter how much higher than that the stock has risen. They can then keep these shares or immediately sell them for a profit, less the premium they paid.
If Disney stock stays below $140 through October 31, the option contract expires and no shares trade hands.
Risks of Call Options
For the buyer of a call option, the primary risk is that the market price of a stock won’t rise above the option’s strike price. If the price of a share stays below the strike price, it’s cheaper to buy the shares on the stock market than to exercise the option.
That means that the option buyer paid the premium to buy the option and received no value in return.
For the person who sells a call option, the risk is that the buyer chooses to exercise the option, typically because the market price moved above the strike price. If the buyer exercises the option, the option seller must sell their shares at the strike price, regardless of their current market price. If they don’t already own the shares, they must buy them on the market and sell them immediately for a loss.
The person who buys the option has limited risk. At worst, they can lose the premium they paid. The option seller has theoretically unlimited risk, as they could be forced to pay any amount of money to buy shares to sell at the strike price.
Put options are the other main type of option. A put option is the opposite of a call option. It gives the option holder the right but not the obligation to sell the underlying security at the strike price. If the market price of the stock falls below the strike price, the option holder can exercise the option to sell their shares at the strike price, no matter how far the stock’s market price has fallen.
For example, someone might buy an option that lets them sell shares of Apple for $100. If shares in Apple fall to $95, the person holding the option can exercise it. If they already own Apple shares, they can sell them for more than they’d be able to get on the open market. If they don’t own Apple shares, they can buy 100 shares on the market for $95 each and exercise the option to sell them for $100 each, netting a $5 profit for each share, less the premium paid for the option.
The person who sold the option must buy the shares at the strike price if the holder exercises the option. They can choose to continue holding those shares or to sell them immediately at the current market price. Because the option holder will typically only exercise the option if the strike price is higher than the market price, the option seller would have to sell the shares for a loss if they wanted to immediately sell the shares they’ve bought.
Risks of Put Options
For buyers of put options, the risk is that the market price of the underlying security will remain above the strike price. If the price never falls below the strike price and the option expires, it will never make sense for the buyer to exercise the option.
For put sellers, if the market price falls below the strike price, the buyer could exercise the option, forcing them to buy shares for more than they would have to pay on the open market.
As with calls, the person buying the put has limited risk. At worst, they can lose the premium they paid to buy the option. The seller of the option also has limited risk, although their risk is typically much higher than the buyer’s risk. The formula for the worst loss the put seller could experience is:
(100 * number of contracts * strike price) = worst possible loss
This loss would occur if the market price for a stock goes to $0. If this were to happen, the option seller still must buy the worthless shares at the strike price, and won’t be able to sell them to recoup any of their money.
There are two primary factors that determine an option’s price.
One is the intrinsic value of the option, meaning the difference between the option’s strike price and the market price of the underlying security.
For call options, a contract will grow more valuable as the market price rises nearer to or above the strike price. For example, an option with a strike price of $100 for a security priced at $95 will be worth more than an option with a strike price of $90.
For put options, a contract gains value as the market value falls nearer to or below the strike price. The lower the market value of the security in comparison to the option strike price, the more valuable the option is.
The other component of option value is time value.
Options have expiration dates. Once an option expires, the option holder can’t exercise it anymore, making it worthless. The closer an option’s expiration date is, the less valuable that contract will be. Similarly, the farther away the expiration date is, the more valuable the contract is.
Keep in mind that this means that options are constantly losing value. With each day that passes, the expiration date nears, reducing the time value of the option. For an option to gain value, it must gain enough intrinsic value to offset the loss in time value.
Options Trading Strategies
These are a few of the most basic option trading strategies.
Buying calls is a basic bullish strategy. Investors who buy calls believe the price of a company’s shares will increase.
Buying calls is popular because it lets investors leverage their portfolio. For example, on September 16, 2020, one share of the exchange-traded fund (ETF) SPY cost about $340. One call option for the same ETF with an expiration date of September 30 and a strike price of $345 cost $328.
For a bit less than the price of one share of the ETF, an investor could buy a call that controls 100 shares. A small rise in the price of the underlying will cause a much larger increase in the price of the option, increasing the investor’s gains.
At the same time, leverage means increasing volatility. If the ETF’s value falls, the fall in the option’s value will be much larger.
Another reason that buying calls is popular is their limited risk. At worst, the buyer can only lose the premium they paid, which reduces the risk of losing their entire portfolio, which other forms of leverage can cause.
Buying puts is a basic bearish strategy. Investors buying options believe the underlying shares will lose value.
Like call options, buying puts is popular because they let the investor leverage their portfolio. One option contract controls 100 shares but typically costs only as much or less than a single share, depending on the strike price.
Puts are also popular because they let the investor profit from price decreases. With typical investing — buying and selling securities — you have to buy low and sell high to profit. There’s no real way to profit from a security that loses value without options.
Buying puts is also appealing because the option buyer’s losses are limited to the premium they paid, which makes it easier to avoid losing their entire portfolio.
Selling Covered Calls
A covered call is a strategy that investors can use to produce extra income from their portfolio of stocks or ETFs.
When you sell a call to someone, you receive income in the form of the premium that person paid to buy the call option. As long as the person doesn’t exercise the option, you get to keep the premium as profit.
A covered call is a call sold for shares that you already own. For example, if you own 100 shares of Twitter stock and sell a call for Twitter, the call is covered because you own the shares you would have to sell if the option holder chooses to exercise the contract.
To sell a covered call, you typically sell the call option with a strike price above the current share price. For example, on September 16, one share of Twitter costs roughly $40. You might sell a call with a strike price of $45 and an expiration date of October 2 for a premium of $0.43 per share. This would net you a payment of $43.
If Twitter’s stock price stays below $45, you get to pocket the $43 in profit and keep your shares. If the price rises above $45, the option holder will likely exercise the option. You’ll sell your 100 shares, receive $4,500, and get to keep the $43 premium payment.
Because you already own the shares, your losses are limited to losing the shares you own. If you didn’t own the shares and sold the call, you could lose an unlimited amount because you’d have to buy new shares at whatever the current market price is in order to fulfill your obligation to sell.
A protective put is a strategy that investors can use to limit their potential losses from holding a security. It functions similarly to an insurance policy.
For example, you could buy 100 shares of Starbucks stock. On September 16, one share costs about $89, so you would pay about $8,900. You could also buy a put option with a strike price of $80 and an expiration date of October 30. Buying the option would cost you about $121.
If Starbucks price falls below $80, then you can exercise the option to sell your shares for $80 each. This limits your potential loss to $9 per share, or $900. In the worst-case scenario, you’ll lose $900 + the $121 you paid for the option. Without the option, you could lose all $8,900 you invested if Starbucks’ share price falls to $0.
If the share price stays above $80, you won’t exercise the option. You’ll lose out on the $121 you paid for the option and have to deal with any losses if Starbucks’ share price dropped to somewhere between $80 and $89.
A straddle is a more complex option strategy that lets an investor earn a profit if a company’s shares experience a large change in value, regardless of whether the change is an increase or a decrease in value.
To execute a straddle, an investor buys two options, one call and one put. Both options should have the same strike price and expiration date.
If the stock gains a lot of value, the trader can exercise the call option to buy shares below market price and sell them for a profit. If the stock loses a lot of value, they can exercise the put option, buying shares at market price, and selling them for an immediate profit to the option writer.
If the stock doesn’t experience a change in price, the option buyer won’t exercise either option and will lose out on the premiums they paid to purchase both options.
Risks of Options
It’s important to emphasize the risk involved in trading options.
Selling options tends to be much riskier than buying options. With the exception of selling covered calls, selling an option involves large, sometimes unlimited risk. You can earn income from the options you sell, but one instance of bad luck could lead to you losing your portfolio.
Buying options is less risky because the most you can lose is the premium paid. Still, options inherently involve a significant amount of leverage. This makes them far more volatile than normal securities like stocks and ETFs.
A 1% change in the price of a security can cause the value of an option to change by 25%, 50%, or even more depending on its strike price and its expiration date.
Trading options without fully understanding how they work or how volatile they can be is dangerous and could lead you to lose significant amounts of money.
Options are a popular way for traders to leverage their portfolios, hedge their bets, or profit from decreases in a security’s price. Despite their popularity, options can be highly risky and should only be used by experienced traders who can handle their risk. Products like Motley Fool Options will give you the tools you need to learn how to properly invest in options.