Stock Option

What Is a Stock Option?

A stock option gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise. 

Understanding Stock Options

Options are a type of financial instrument known as a derivative — their worth is based on or derived from, the value of an underlying security or asset. In the case of stock options, that asset is shares of a company's stock. Essentially, the option is a contract, an agreement between two parties to sell/buy the stock; the option contract sets the date of the transaction (usually a few months into the future) and the price.

When a contract is written, it determines the price that the underlying stock must reach in order to be "in the money", known as the strike price. An option's value is determined by the difference between the underlying stock price and the strike price. 

Stock options come in two basic categories:

There are two different styles of options: American and European. American options can be exercised at any time between the purchase and expiration date. European options, which are less common, can only be exercised on the expiration date.

Expiration Date

Options do not only allow a trader to bet on a stock rising or falling but also enable the trader to choose a specific date when they expect the stock to rise or fall. This is known as the expiration date. The expiration date is important because it helps traders to price the value of the put and the call, which is known as the time value, and is used in various option pricing models.

Strike Price

The strike price determines whether an option should be exercised. It is the price that a trader expects the stock to be above or below by the expiration date. If a trader is betting that International Business Machine Corp. (IBM) will rise in the future, they might buy a call for a specific month and a particular strike price. For example, a trader is betting that IBM's stock will rise above $150 by the middle of January. They may then buy a January $150 call.

Contracts

Contracts represent the number of options a trader may be looking to buy. One contract is equal to 100 shares of the underlying stock. Using the previous example, a trader decides to buy five call contracts. Now the trader would own five January $150 calls. If the stock rises above $150 by the expiration date, the trader would have the option to exercise or buy 500 shares of IBM’s stock at $150, regardless of the current stock price. If the stock is worth less than $150, the options will expire worthless, and the trader would lose the entire amount spent to buy the options, also known as the premium.

Premium

The premium is determined by taking the price of the call and multiplying it by the number of contracts bought, then multiplying it by 100. In the example, if a trader buys five January IBM $150 Calls for $1 per contract, the trader would spend $500. However, if a trader wanted to bet the stock would fall they would buy the puts.

Trading Options

Options can also be sold depending on the strategy a trader is using. Continuing with the example above, if a trader thinks IBM shares are poised to rise, they can buy the call, or they can also choose to sell or write the put. In this case, the seller of the put would not pay a premium but would receive the premium. A seller of five IBM January $150 puts would receive $500.

Should the stock trade above $150, the option would expire worthless allowing the seller of the put to keep all of the premium. However, should the stock close below the strike price, the seller would have to buy the underlying stock at the strike price of $150. If that happens, it would create a loss of the premium and additional capital, since the trader now owns the stock at $150 per share, despite it trading at lower levels.

Real-World Example of Stock Options

In the example below, a trader believes Nvidia Corp’s (NVDA) stock is going to rise in the future to over $170. They decide to buy 10 January $170 calls which trade at a price of $16.10 per contract. It would result in the trader spending $16,100 to purchase the calls. However, for the trader to earn a profit, the stock would need to rise above the strike price and the cost of the calls, or $186.10. Should the stock not rise above $170, the options would expire worthless, and the trader would lose the entire premium.

Image by Sabrina Jiang © Investopedia 2020 

Additionally, if the trader wants to bet that Nvidia will fall in the future, they could buy 10 January $120 Puts for $11.70 per contract. It would cost the trader a total of $11,700. For the trader to earn a profit the stock would need to fall below $108.30. Should the stock close above $120 the options would expire worthless, resulting in loss of the premium.

Why Would You Buy an Option?

Essentially, a stock option allows an investor to bet on the rise or fall of a given stock by a specific date in the future. Often, large corporations will purchase stock options to hedge risk exposure to a given security. On the other hand, options also allow investors to speculate on the price of a stock, typically elevating their risk.

What Are the Two Types of Stock Options?

When investors trade stock options, they can choose between a call option or a put option. In a call option, the investor speculates that the underlying stock’s price will rise. A put option takes a bearish position, where the investor bets that the underlying stock’s price will decline. Options are purchased as contracts, which are equal to 100 shares of the underlying stock.

How Do Stock Options Work?

Consider an investor who speculates that the price of stock A will rise in three months. Currently, stock A is valued at $10. The investor then buys a call option with a $50 strike price, which is the price that the stock must exceed in order for the investor to make a profit. Fast-forward to the expiration date, where now, stock A has risen to $70. This call option would be worth $20 as stock A’s price is $20 higher than the strike price of $50. By contrast, an investor would profit from a put option if the underlying stock were to fall below his strike price by the expiration date.