What is a stock option? That is the first question I always get when I tell people about my business. Most people understand the concepts underlying stock investing and trading, and they know options are somehow related, but how? Although there are many ways to view options, depending on how you want to use them, this article will address options as a substitute for stock. Please also check out our site to learn more about option volatility trading.
A stock option is a legal contract giving the owner the right to buy or sell a quantity of stock at a set price on or before a specific date.
This definition was written in regard to stock options but is not limited to stocks. Options are used in many other markets including real estate, bonds, futures and commodities, indexes, ETFs and even "exotic" market. Yes, there is an exchange that will let you write an option on just about anything.
Please note I stated it is a "legal contract." A stock option is regulated by the SEC, managed by the Options Clearing Corporation, and is standardized. Because of this imposed structure, a stock option is traded on an exchange very much like stock. These option exchanges give the market liquidity by bring buyers and sellers together efficiently, and enables rapid execution of orders.
A stock option can come in two varieties: calls and puts.
A CALL option gives the owner the right to buy the stock at a fixed price over a fixed period of time. Note that it is a right and not an obligation. The owner of the call does not have to buy the stock but probably will if there is an advantage to do so. The person selling the call option is obligated to sell the stock if the option buyer exercises their option (the right to buy). The buyer can call the stock away from the seller, thus giving it the name, call option.
A PUT option gives the owner the right to sell the stock at a fixed price over a fixed period of time. As with a call, it is a right and not an obligation. The put owner does not have to sell the stock. The person selling the put option is obligated to buy the stock if the option buyer exercises their option (the right to sell). Like a call, the put gets it name because the buyer can put the stock to the seller.
A stock option can be used as a substitute for stock.
Let us assume you are bullish. You believe XYZ stock will increase in value over the next 2 months. Today XYZ's shares are selling at $50 per share and the 2 month out call option giving you the right to buy at $50 per share is selling for $2 premium. This option is said to have a strike or exercise price of $50, and since a stock option usually covers 100 shares, it will cost a total of $200 plus commissions. But buying 100 shares of XYZ at $50 each would cost $5,000 or 25 times more. This is called leverage. By buying the call option you can control $5000 worth of stock for $200 over the next 2 months.
Since you are an excellent student of the market, you were correct in being bullish. Over the next month, the stock went to $60 per share. The call you own now has a premium of $11. Let us assume you exercise your stock option at this point. You buy the stock at the strike price of $50 per share. Now you could immediately sell at $60 and realize $800 profit ($10 per share or $1000 less the $200 for the option) or hold the stock at a basis of $52 per share and hope it continues increasing in price.
Instead of investing more of your funds in exercising the call option, you could just sell the call option. It now has a premium of $11 and can be sold for that price. Since the stock option covers 100 shares, you would get $1100. The profit realized is now $900 or 450% profit (sell at $11, bought at $2).
Being long (buying) a put is just the mirror image of the call. You are now bearish and believe that XYZ will go down over the next 2 months. Again, today XYZ's shares are selling at $50 per share and the 2 month out put option giving you the right to sell at $50 per share is selling for $2 premium. Over the next month the stock goes to $40 per share and your put option premium is now $11. If you sell the put option, a $900 profit will be realized. Note this was like shorting the stock but you were not subject to the up tick rule (to be explained in another article).
Stock option trading is not for everyone because it can be more risky due to the time limit and requires you to watch the market more closely. But note that purchasing the stock option involves less commitment of funds and generates higher returns if you are correct in your market forecast. Using option volatility trading techniques, you can even profit whether the market is going up or down but you do not have to forecast direction.