How Do Stock Options Work?

Key takeaways

• An option is a contract that allows the buyer to buy or sell shares of stock at an agreed-upon price.
• Investors can get outsized returns by using options instead of simply owning stocks.
• Be forewarned that higher rewards come with higher risk. Knowing how to hedge your positions to protect yourself from potentially unlimited losses is imperative.

Everyone knows that you can make money investing in stocks by buying low and selling high. However, there are ways to make money in the stock market even when prices are down and volatility is up. Selling options is one strategy that can be lucrative but risky.

Read on to learn how options work, the risks, and how to get started.

What is an option?

Much like it sounds, an option gives you the opportunity (but not the obligation) to buy an asset at an agreed-upon price. While options generally refer to stocks, they are sometimes used in real estate. For example, rental properties may have the opportunity to buy at the end of the lease.

The buyer pays a premium for the option regardless of whether they actually buy the asset. Usually, this is a set dollar amount per share. This is a win for the buyer, who gets the asset at a price they like, and the seller, who makes money on the deal regardless of whether or not they sell.

Options don’t last forever. Like grocery store coupons, they come with an expiration date that they must be used. Otherwise, they become worthless.

Types of options

There are only two types of options, including calls and puts. These two varieties can be mixed and matched in endless combinations ranging from simple, including covered calls, to complex, such as iron condors.

Here are the basics of each option type and common situations when investors use them.

Call options

A call option allows the buyer to purchase (or call away) shares of stock at a particular price. It also obligates the seller of the option to sell their shares at that price if called upon to do so.

For example, say you want to own 100 shares of ABC stock. Let’s say it’s trading at $50 per share, and you buy at this price for a total of $5,000. If ABC stock rises by 10% to $55 per share in the next six months, your portfolio will grow to be worth $5,500. Your $5,000 investment is now worth 10% more.

Now let’s say that instead of buying the stock, you purchased a call option that allows you to call for someone else’s shares at a specific price. In this example, the price (known as the strike price) is $50 per share. You’ll pay a premium for this option, let’s say $1.00 per share ($100 total). Instead of spending $5,000 to own ABC stock, you can buy it at the same price with only spending $100 for the call option.

If ABC stock rises the same 10% to $55 a share, your $100 is now worth $400. This is an increase of $5 per share multiplied by 100 shares minus the $100 premium, which translates to a 400% return. If you’d spent the same $5,000 on options as you did on ABC stock in the first scenario, you’d now have $200,000.

However, you lose money if the stock doesn’t increase by more than $1 per share in six months. Exercising your option will only make sense if the stock price increases since you would pay more at the strike price than it’s trading for in the market. If you bought ABC stock outright without options, you’d still have the asset and could wait to see if it went up in price later.

Buying options is cheaper than buying stock, but you could lose your entire investment if your predictions are incorrect. Consequently, it’s important to calculate your potential losses so you only lose what you can afford.

One additional note to keep in mind, dividends go to the owner of the shares, not to the owner of the call options. You do not get dividends with options.

Put options

A put option works in the opposite way. It gives the buyer the right to sell shares at a specific price and the seller the obligation to buy those shares if the option is exercised. Put options are often compared to insurance because they protect your investment against loss from a stock going down in price since you can still sell at the original (presumably higher) strike price.

Let’s take the same example of ABC stock at $50 per share. If you bought ABC stock at $50 but were worried about the stock’s price going down, you might purchase a put option with a strike price of $50 that expires in six months at $1 per share. If the stock drops to $45 per share and you exercise your option, you’d be out your $100 premium, but you’d still have $4,900 rather than 100 shares of ABC stock worth only $4,500.

Puts are designed as hedges against loss, not moneymakers. But, if you exercised your put in the above example, you could buy back the stock at $45 a share and pocket $400. Here’s how that works, sell the stock at a strike price of $50 per share for $5,000, subtract the $100 put option and you’re left with $4,900. When you buy 100 shares at $45 it will cost $4,500 and you will have $400 as profit.

Of course, if the price of ABC goes up instead of down, you’re out the $100 with nothing to show for it. You’d be better off selling on the exchange rather than selling at your now-lower strike price, so your put is worthless. But just like with insurance, you usually buy a put hoping not to use it.

Trading options

The interesting thing about options is that you don’t have to actually own the underlying stock. You can trade options as their own entities. However, this can be extremely risky.

When the stock price underlying your option changes, it can make it worth more, and you can sell an option without exercising it. For instance, if the stock price moves above the strike price on a call option you bought, your option is now more valuable. You have the right to buy the stock at a lower price than it’s currently trading at, so you can exercise the option, sell the stock, and pocket a nice profit.

To simplify things, you can sell the option before it expires. Like bonds, options are traded on the secondary market.

Terms to know

If you are thinking about trading stock options, there are a few important terms you should know. These include:

• In the money (ITM): An option is in the money when the stock price has altered to make the option worth exercising after accounting for the cost of the premium. In the put example above, the option would be in the money once the stock dropped below $49 per share ($50 initial price – $1 premium per share = $49).
• Out of the money (OTM): Conversely, an option that is out of the money is not yet worth exercising. Using the same put example, the option would be out of the money at $49 per share or more. It only makes sense to exercise the option once the stock price drops further.
• Time value (Theta): Options are worth more when the expiration date is further away. If an option expires in a few days, you’re less likely to be able to use it, so it has less time value. An option’s value is calculated based on the underlying stock’s price and how much time value is left. Time value is often expressed as the Greek letter theta.
• Holder: This is the person who buys the option contract and has the right to exercise it.
• Writer: This is the person who sells the option contract and is obligated to fulfill it if the holder exercises the option.
• Contract: Options come in contracts of 100 shares each, so you must buy a minimum of 100 shares’ worth of the option you purchase.

The risk of selling options

While there is tremendous upside to trading options, they come with risks. When you buy an option, the worst that can happen is that the stock moves against your position. In this scenario, your option expires, unexercised and worthless. The most you can lose is what you paid for the option.

However, selling an option without any underlying asset, also known as a naked call or a naked put, has a similar loss potential as selling short (infinite).

For example, say our ABC stock is trading at $50, and you write a naked call contract (meaning you own no ABC stock) at a $55 strike price of $1.00 per share. The best-case scenario is that the stock goes down or stagnates, and the option expires. You’d keep the $100 profit, which you got for basically nothing.

However, if the stock price goes up and your option gets exercised, you are now short the stock. You must sell 100 shares of ABC so that you don’t have to fulfill the call contract, meaning you are forced to buy shares at the market price, which could theoretically be infinitely high. Since you could pay any price for the shares you now need, your losses could also be infinite.

This is why many experienced options traders use combinations of calls, puts, cash, and underlying stock to hedge the risk of selling options. Otherwise, the sky-high risks can outweigh the hefty rewards of trading options.

The bottom line

Trading options has a much stronger upside than trading stocks, but it takes a lot of know-how and strategy to minimize the risk. While your money can go much further purchasing options than stocks, greed has ruined many a would-be options trader prematurely. Before jumping in, beginners should educate themselves on the risks of options trading.

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