A stock option is an investment derivative that serves as a contract for the buyer to have the right, but not the obligation, to purchase or sell shares of stock at a predetermined price and date. The contract for the right to buy or sell can be traded itself, much like actual shares of stock may be traded. The option holder has the right to exercise the option at any time prior to the expiration date specified. The price of the option is called the premium, and is usually a small percentage of the stock price.
If the option holder purchases the right to buy a stock it is referred to as a call option, if the right to sell a stock, it is a put option. If the options contact is not “in the money” based on the strike price when the expiration date passes, the options become worthless.
How to Trade Options
If an investor is currently tracking stock and believes the share price will rise in value in the coming months, rather than purchasing shares of the stock itself, they can purchase a call option that grants them the right to purchase the stock within a predetermined period of time at a strike price. By using an option instead of owning the shares outright, the investor can hedge their exposure and risk, and still benefit from any upward movement of the stock price.
As an example, if an investor is watching stock ABC, which is trading at $10 per share. Instead of buying and holding 100 shares of the underlying stock for $1,000, they can purchase a call option for $0.10 per share, or $100, with a strike price of $12 per share.Since each option contract represents 100 shares of the underlying stock, all prices are multiplied by 100. If the share price rises to $15, then the investor can exercises the call option and sell the shares of stock on the open market at the current trading price.
$15 (current price) – $12.10 (strike price + premium) = $2.90 x 100
With an investment of $100, the investor stands to profit $290 in this scenario. However, the drawback of options is if the strike price is not met by the expiration date, the options will become worthless and the investor will have lost the entirety of the $100 they paid on the premium. Usually, the closer the strike price is to the underlying stock’s current price and the longer the time horizon is between the date of purchase and the expiration date, the higher the premium will be. One common mistake made by many novice options investors is to purchase contracts that are too far out of the money, and thus, the strike price is never reached.
Features of Stock Options
- An investor purchasing an option obtains the right to purchase (or sell) the underlying stock. The investor is under no obligation to do so, however.
- Most traded stock options expire on their own without being exercised by the owner of the option.
- Stock options are commonly traded on major stock exchanges, including the New York Stock Exchange and the American Stock Exchange. They are regulated by the SEC.
- Stock options are a part of the derivative market.