Stock Options Explained

Buying stocks is not the only way to make money from the stock market. Stock options are another financial instrument capable of taking advantage of the change in a stocks price. Stock options are a little more complex than simply buying and selling stocks but understanding them can unlock powerful strategies that can add substantial gain to any portfolio. This article will give you the basics of options trading so that you can begin to explore this exciting area of finance.

What are Stock Options?

Stock options are a financial instrument that gives the owner the right, but not the obligation, to buy or sell a particular stock at a specific price on or before a specific time. Two main types of options exist, call options and put options. Options differ from each other by specific characteristics given to them, such as, the underlying stock involved, the expiration date of the option, the strike price and even the amount of shares the contract is good for.

What is a strike price?

The strike price is the price the underlying stock needs to be above or below to be considered "in the money". For call options the underlying stock price must be above the strike price of the option contract but for put options the underlying stock price needs to be below the strike price for it to be "in the money".

What does "in the money" mean?

Stock Options Explained.

Being "in the money" determines whether the option will be exercised. Brokers will automatically exercise "in the money" options at expiration if they are not exercised before then. Options that are not favorable to the buyer of the option are said to be "out of the money." An option that reaches the expiration date "out of the money" expires worthless and the buyer of that option contract lost any principal he may have paid for that contract. The phrase "in the money" will often be shortened to "ITM".

What does it mean to exercise an option?

An option should only be exercised if there is a promise of immediate profit behind it (aka the option is "in the money"). Exercising a call option requires the creator of the option to sell 100 shares to the owner of the option contract at the strike price. For example if I created a call option with a strike price of $5 and I sold it to you and then a week later you decided to exercise it, I would have to give you 100 shares of the underlying stock and in exchange you would pay me $5 for each one ($500 total).

Put options work in a similar way but almost in the reverse order. Exercising a put option requires the creator of the option to buy 100 shares of stock from the current owner of the option contract at the specified strike price. For example if I created a put option with a strike price of $5 and sold it to you and a few weeks later you decide to exercise it then I would have to give you $500 and you would have to give me 100 shares of the underlying stock.

How do I make money with options?

Making money with options is very straight forward if you understand the basics. If you think a stock will go up in the future you would want to buy a call option. This allows you to obtain contract to buy stock at a lower price than it will be in the future. As an example, if you buy an option with a strike price of $2.50 and the stock shoots up to $5, you still have the option to buy 100 shares of the stock for $2.50.

This means that, in essence, you are able to buy 100 shares of stock at a 50% discount. You can purchase those shares for $250 total and then immediately sell them on the regular stock market for $500 essentially doubling your money. Put options can be very profitable as well, however you should only buy these if you think a stock will go down in the future instead of up.

If you bought a put option with a strike price of $10 and the price suddenly sunk to $5, you could sell 100 of your own shares of the stock to the creator of the option still at $10 a share even though they are only worth $5. Put options act as insurance from sudden price drops in stocks and this way the stockholder doesn't lose any principal investment in the stock.

What does it mean when an option expires?

Upon creation of an option a date is given for the contract to expire (usually a Friday). Some options have weekly expiration dates, usually higher trading volume stocks will have weekly expiration dates. Other options only have expiration dates that occur once a month or so. The creator of the option gets to choose from an available list of expiration dates.

The buyer of options gets to chose from a list of options with varying strike prices and expiration dates and and will purchase an option based how they predict the underlying stock will perform in the future. When an option expires if it is "in the money" it gets exercised and shares and money will change hands between the buyer and the seller of the option. If the option reaches expiration and its "out of the money" then it will expire worthless and the buyer and sell never exchange any money or shares and the contract disappears essentially.

What happens when an option is exercised?

Call Options Put Options
Buyer pays 100 times strike price Seller pays 100 times the strike price
Seller gives 100 shares of underlying stock Buyer gives 100 shares of underlying stock

Fun Fact: European options allow a buyer to exercise the option only when the maturity date has been reached. American options allow the buyer to exercise the option anytime before the expiration date.

How are options valued?

An option has 2 main parts to its value, intrinsic value and time premium. Intrinsic value only exists if the option is "in the money". The intrinsic value is determined by calculating how much money you could make (minus trading fees) if you were to exercise that option immediately.

Time premium on the other hand is independent from strike price and the underlying stock price. Time premium is based on how much time is left until this option expires. Time premium exists because the longer an option is valid for the more things can happen in that time period to effect the underlying stock price.

For example if I think a stock is going up, I will buy a call option but if I buy an out of the money option and it expires next week that might not be enough time for the stock to gain enough value to put the option "in the money". However if I bought a call option with the same strike price but an expiration date that was 6 months away, that gives the stock a longer period of time to gain value and gives me more of a chance of my option expiring "in the money".

Generally as an option approaches the expiration date and the underlying stock price hasn't moved much, the value of the option will decrease due to the time premium dropping in value. This is commonly referred to as time decay and is measured by the greek letter theta for each stock option.

What is Theta?

Theta represents how sensitive a stock option is to time decay. Time decay is when a stock options value decreases as the expiration date creeps closer. The greek letter Theta is an indicator used by stock traders around the world to assist in the valuation and prediction of options prices.

Selling Options

Some trading platforms allow you to sell options even without owning any. This is called creating an option or shorting an option. This can have some serious risks involved but can also offer some very healthy returns.

Selling Put Options

When you sell a put option, you are agreeing to buy a stock at a particular price (the strike price). You earn the premium paid by the buyer for the option and hope that the option stays "out of the money". For put options you must offer cash upfront as collateral in case the option you sell gets exercised before the expiration date. The platform needs to know that you have the money to honor the contact you are about to sell. This amount is whatever the strike price is multiplied by the number of shares in the contact (usually 100).

If the put options ends up "in the money" and the option is exercised or expires, you will be required to buy the stock at the strike price, even though it is trading at a lower price in the market. The buyer of the put option hopes that the price of the stock goes down so that the seller of the put option will have to pay a higher price for their stock than the market will. The seller hopes that the price of the stock continues to remain above the strike price so that the option expires worthless and he or she has no obligation to buy the stock.

For example if I want to sell a put option with a strike price of $5, the platform would require me to put $500 in its escrow account and will then give me an option to place in the options market and I can sell it and hope that it expires out of the money. When the option expires out of the money or you buy the option back your $500 is released from escrow back to you and you may use it to buy stocks or options or short another option.

Selling Call Options

When you sell a call option, you are agreeing to sell a stock at a particular price. Like with selling put options, you earn the premium from selling the option. Unlike with selling put options, you hope that the price remains under the strike price. Selling call options don't require any cash up front. However you need to own 100 shares of the underlying stock and offer that as collateral to the trading platform in assurance that you can pay the option in case it get exercised by the buyer. Buyers of put options hope that the price goes up so that the option enables them to buy the stock at the cheaper strike price.

As the potential upside of a stock is unlimited, so too is the potential loss when it comes to selling call options. The buyer of the option is only limited in his or her loss to the premium paid for the options. Lets say I want to sell a call option with a strike price of $5. I need to own 100 shares of the underlying stock and the platform will lock them in escrow, meaning you cant sell them. If the buyer of my option wishes to exercise it then I would lose the 100 shares in escrow but I would receive $5 for each share ($500 total).

How do I trade options?

Many traditional stock brokers allow you to buy and sell stock options. Before doing so, the Securities and Exchange Commission (SEC) requires that you file an application with your broker. This application typically requires you to divulge your income and net worth. It also asks what type of options you are interested in trading and what your previous trading experience is. After you submit your application, the broker will then decide what risk category you fit into and decide what types of options they will allow you to trade.

What are option premiums?

The value of an option at a specific point in time is called the options premium. The premium usually consists of 2 main parts, the options intrinsic value and the options extrinsic value. The premium of an options changes in relation to a change in stock price and even the passage of time will effect the premium of an option.

What is intrinsic value?

Intrinsic value is the value a stock option has only if it is currently "in the money". Out of the money options do not have intrinsic value at all. Intrinsic value is derived from how much money you could make by exercising that option immediately. For example, if I have a $1 call option and the underlying stock is currently trading at $2.50, my option has an intrinsic value of $1.50.

If an option is out of the money, then it would not have an intrinsic value because if you decided to exercise then you would not make any profit. For example, if I owned a $2 call option but the underlying stock is currently trading at $1 per share then the option would be out of the money and the intrinsic value would be $0. However, we know that out of the money options still carry some premium. That is where extrinsic value comes into play.

What is extrinsic value?

Extrinsic value adds to the premium an option may have and corresponds to its probability of expiring in the money. The two biggest factors that assist in the formula for extrinsic value are time until expiration and volatility of the underlying stock. We learned earlier about time decay and how it effects the options premium in a negative way for option buyers. That is an example of extrinsic value eroding away as the passage of time continues.

If I have 2 call options at the same strike price for the same underlying stock but different expiration dates, the one that takes longer to expire will have a higher extrinsic value than the one that expires sooner, but why? This is due to the fact that a stock price can move further from the current price if it is given more time to do so. So to options buyers this gives them a feeling that there is a higher probability of an option expiring in the money.

Volatility is another reason a stocks premium is higher than its intrinsic value alone. Volatility is how far up or down a stock is expected the move within a certain time. The higher the volatility, the further from the current price the stock is expected to be able to move and thus gives option buyers a higher feeling of certainty that their option has the ability to expire in the money. Generally the extrinsic value of an option will decline as the expiration date gets closer, but if volatility goes up during that period that could significantly increase your options value as well.

Final Thoughts

Options provide a different way to profit from changes in stock price. Buying call options and selling put options limit your risk to a finite amount of money and offer unlimited potential for profit. Selling call options and buying put options offer unlimited risk but give you a finite return. Selling stock options can be a great way to earn income from stock you intend to hold for a long time.