As you get beyond the basics of buying and selling stocks, you might want to understand how stock options can play a key role in your investment portfolio. They are part of a larger group known as derivatives.
What are derivatives?
Derivatives obtain their value from another asset. In this case, stock options are derivatives of the underlying stock they track. The value of the stock options comes from (is derived) from the value of the stock.
The most common type of derivative is insurance. During the Great Recession, you may have heard of credit default swaps (CDS). These insurance products, which protected against the risk of default, derived their value from the underlying assets they insured.
When many of the mortgages went belly-up, these instruments became extremely valuable because they could offset the losses from those mortgages.
What are stock options?
Stock options are contracts for the right to buy or sell a certain amount of an asset (in this case, shares of stock) at a given price, known as the strike price. These contracts are valid until the expiration date.
Stock option contracts come in lots (groups) of 100 shares, where each contract represents one lot or 100 shares. Most options contracts are “American style” in that they can be used any time up until expiration.
“European style” options can only be exercised at the expiration date. Options contracts come in two different flavors: Puts: The right to sell a stock. Calls: The right to buy stock.
Here’s a couple of easy examples of how stock options work:
Jon buys one contract for IBM at a strike price of $150 that expires in three months. The current price of the stock is $155. If IBM dips below $150, to $145, any time up until expiration Jon can exercise his right to sell 100 shares of IBM at $150.
If he did this when the stock was at $145, he could simultaneously buy 100 shares for $145 and sell them for $150, making a profit of $5 per share.
Jon buys one contract of CSX at a strike price of $45 that expires in one year. The current price of the stock is $30. If the price of the stock shoots up to $55 on the day of expiration, Jon can exercise his option to buy 100 shares of CSX at $45 and then sell them at $55 on the day of expiration, making a profit of $10 per share.
If a contract reaches expiration and the underlying stock for a put option never falls below the strike price, the options contract expires, worthless. Similarly, if a stock never goes above a strike price for a call option by expiration, the contract also expires, worthless.
3. Stock option components
Stock options have a few special vocab words to know before trading them:
- Expiration date: Date up until which an option contract is good
- Strike price: Contracted price by which the contract can be exercised.
- Option premium: Cost associated with purchasing or selling an option made up of intrinsic and extrinsic values.
- Intrinsic (in-the-money) value: Value between a stock option strike price and the underlying stock’s price.
- Extrinsic value: Value paid on a contract based on external factors of time and volatility.
- Implied volatility: The expected or forecasted volatility in a stock over a certain number of days.
What’s worth noting is the price you pay for an options contract comes from the intrinsic value plus the extrinsic value. Generally, the more volatility a stock has or the longer you want an option contract to be held open, the more extrinsic value it has.
How to trade stock options
Stock options are traded similarly to stocks. However, the implications of what they mean are very different.
Buying a stock option
When you purchase an options contract, you’re said to be long the contract. Being long a call contract is a bet the stock will go up, while being long a put is a bet the stock will go down. Your losses are limited to the total price you paid for that options contract known as the premium. In order to break even, you must be able to sell the options for more than you paid or exercise options that allow you to cover the cost of your premium.
Selling (writing) a stock option
If you short a stock, you could, in theory, lose an infinite amount of money. In some cases, writing options can have the same effect. When you write a call option, you’re providing someone the right to buy stock off you at a strike price, and in return you receive a premium. In theory, the stock could go to infinity, and your losses could be unlimited.
When you write a put option, you are limited to the strike price multiplied by 100 shares of the stock. If you’re interested in opening a brokerage account to trade options, check out Benzinga’s guide to opening a brokerage account.
How to use stock options
Stock options provide a number of valuable ways to invest and manage your portfolio.
- Speculation: Stock options themselves can be used as a bet a stock will go up or down in the same way that purchasing or shorting a stock does. However, options limit your exposure and provide leverage in return for a premium.
- Hedge: As noted earlier, options can be used as a type of insurance. Investors often use options as a way to protect stocks within their portfolio.
- Alternative investment: One way that many investors and traders use options is as an income stream through selling options. There are a variety of strategies that allow investors to collect premiums while managing their risk.
Corporate and employee stock options
Though not often talked about in investing circles, corporate and employee stock option contracts provide a common way for executives and management to receive bonuses. Oftentimes, CEOs will have option contracts available to them, which incentivizes them to work at increasing the share price of the company.
Although most retail investors consider stock options as one-way bets on a stock, a variety of strategies exist that allow anyone to become institutions. Some investors build entire portfolios of options strategies where they sell options and collect premiums while managing risk. However, if you own stocks in your portfolio, looking for times of low volatility to purchase protection for stocks or using neutral strategies (like collars for high dividend stocks) can augment your returns.