How do stock options work?

by
Mr. The Poor Swiss
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A stock option is an advanced financial instrument. In essence, it is a contract that conveys a right to buy or sell at a specified price up to a specified date.

In my advanced investing series, I want to cover options as I think they are interesting. Now, I do not recommend investing in options, and I have never done it myself either. They are an advanced financial instrument that most people will never need.

Regardless, I believe it is interesting to learn about these advanced instruments. So, let’s delve into the world of options.

Stock Options

There are several kinds of options, but I will only talk about stock options. These are options related to the stock market, specifically related to stocks.

Let’s start with the definition. A stock option is a contract giving the buyer the right (not the obligation!) to buy or sell an asset (here a stock) at a specific price up to a specific date.

Options are part of the group of securities known as derivatives. They are all advanced instruments. There are many derivatives such as puts, futures, calls, forwards, swaps, etc.

The price of an option is called the strike price. And the date of an option is called the expiry date. After the expiry date, an option is entirely worthless (literally worth 0).

Usually, an option is not for a single stock but for 100 shares of a stock (or a multiple of 100 shares).

Options have a price, called the premium. When you buy a stock option, you pay the premium. And when you open and sell a stock option, you will get the premium.

Opening a stock option is called writing a stock option.

There are two types of stock options:

• A call option that gives the right to buy
• A put option that gives the right to sell

We are going to see these with examples below. In my examples, I am going to ignore the transaction fees of options. But in practice, trading options is not free, and the broker will charge you something.

It is interesting to note that European options are different from American options. With a European option, you can only exercise the buy or sell at the expiry date, not before. With an American option, you can exercise at any time before or at the expiry date. This makes American options much more flexible.

Call Stock Options

A call option gives the holder the right to buy a security at the given strike price by the expiry date.

There are two main ways to make money with call options.

The standard way is to buy a call option; an operation called a long call. In that case, the trader expects the underlying security (the stock) to go up in price.

For instance, a trader can buy a call option for 100 shares of stock X at a 2.20 USD premium per share to buy stock X at 100 USD for 3 weeks. So, in total, the trader is paying a 220 USD premium. If the stock goes up to 110 before that date, he can buy 100 shares at 100 USD (10’000 USD), sell them back at 110 USD (11’000 USD) and make a profit of 780 USD (1000 USD – 220 USD).

On the other hand, if the stock stays below the strike price (100 USD), the trader will not exercise its option and let it expire. In that case, he lost 220 USD (the premium).

What is important with this strategy is that the benefit can be very high. In our example, the trader made a profit of 780 USD out of 220 USD. That is more than 3 times his investment. And the stock only made a 10% increase. In practice, the price of the option would likely be higher. But it remains that case the benefit of a call option is virtually unlimited.

On the other hand, the risk is relatively low since you can only lose the premium. Of course, you can lose the entire amount of money if the options expire. But compared to a loss calculated over 100 shares, it is generally interesting to use options.

The second way to make money is to open and sell a call option, called a short call. There are two different types of short calls. The first is a naked call where the seller does not have the share. So, if the buyer exercises his right to buy the shares, the seller will have to purchase the shares and then deliver them. This is quite risky. A naked call has virtually limitless risks. With a naked call, like short selling, there are margin requirements.

The other type is a covered call where the seller already has the shares. In that case, the risks are significantly lower.

On the other hand, the potential gains for a covered call (or naked call) are limited to the premium. The maximum gains are made when the call options expire.

Let’s do an example again. Stock X is trading at 120 USD. A trader is selling call options at a strike price of 125 USD, expiring in two months. The price of the option is 1.50 per share (150 total premium). If the price stays below 125 (or close), the buyer will not exercise his right to buy the shares, and the option may expire. In that case, the seller made a profit of 125 USD.

If the price goes to 110 USD and the buyer exercises the option, the seller will have lost 15 USD per share (125 – 110), which is 1500 USD. The total loss is 1375 (1500 – 125).

Let’s summarize:

• Buying a call option is betting that the stock will go up. This has very high earning potential and low loss potential.
• Selling a call option is betting that the stock will go down. This has low earnings potential (the premium) and very high loss potential (potentially unlimited).

Put Stock Options

A put option gives the holder the right to sell a security at the given strike price by the expiry date.

Again, there are two main ways to make money with call options. Either you buy or sell a put option.

Buying a put option is referred to as a long put. In this case, the trader usually thinks that the price of the stock will decline.

Again, let’s make an example. Stock X is currently trading at 170 USD per share. You buy one option with a strike price of 155 USD, and you pay 0.50 USD per share. The total premium is 50 USD (0.5 x 100). If the price of X goes down to 150, you can exercise your option, sell the stocks at 155 USD and repurchase them at 150 USD. With that, you made 450 USD in profit (100 x 5 – 50).

The benefit of this strategy is high and depends on the price of the stocks (minus the premium). On the other hand, the risks are low since the worst that can happen is to lose your premium (not based on the price of stocks). So even if the price of stocks increases 100%, your option will simply become worthless, and you will have lost the premium. This can be a good alternative to short selling since a short sell has virtually unlimited risk potential.

The second idea is to open and sell a put option, a strategy known as a short put. If the buyer exercises the right to sell, the seller of the option will have an obligation to buy the stock at the strike price. In general, short put traders think that a stock will go up.

Let’s say stock X is trading at 30 USD per share. The investor opens and sells a put option with a strike price of 35 USD at 5 USD per share. If the option is not exercised, the trader will make a benefit of 500 USD (100 x 5). If the option is exercised, the trader has a potential loss based on the difference between the strike price and the current price.

In the worst case, the stock goes down to zero, but the trader has to buy it at 35 USD. In that case, the maximum loss is 3000 USD (35 x 100 – 500). So, the potential loss is not unlimited but can still be large.

Let’s summarize:

• Buying a put option is betting that the stock will go down. This has very high earning potential and low loss potential.
• Selling a put option is betting that the stock will go up. This has low earnings potential (the premium) and high loss potential.

Stock Options prices

Until now, all the examples we have covered have been to exercise the option. But in practice, only 10% of options are exercised. Indeed, in most cases, people try to profit from options not by buying (or selling) the stocks but by buying or selling the options themselves.

For this, we need to understand how options are valued. I will not go into too many details because it is very complicated. Three factors influence the price of a stock option:

1. The time until expiration. The time value of a stock option decays exponentially over time.
2. The current underlying stock price. As the price moves in the valuable direction, the value of the option increases. As the prices in the other direction (losing money), the value of the option decreases.
3. The volatility of the underlying stock. A high volatility stock means higher premiums for the options. And as the volatility of the stock moves, the price of an option moves accordingly.

So, pricing an option is complicated. But selling an option can make significantly more profit than exercising the right of the option.

Let’s make another example again with a long put option. Stock X is trading at 170 USD. You buy one option with a strike price of 155 USD at 0.45 USD per share. Your total premium is 45 USD. If X goes down to 154, your options are worth 1 USD each. If you sell your option, you get 100 USD. You have made a profit of 55 USD. In percentage, this is 122% profit. In that case, the stock went down by less than 10%, and you profited 122%! This is a huge difference.

You could increase your profit by exercising the option. However, this needs a large amount of cash for buying the shares. Mathematically, you are better off buying multiple options and selling them rather than buying fewer stock options and exercising them.

So, buying and selling stock options is a way to make more money than the movements in prices of the stock. But of course, this is a complex strategy since you need to follow the prices of the stocks and the price of the options.

Why buy stock options?

There are several reasons why people buy and sell stock options.

The first reason is profit. This is almost always the main reason to trade. With stock options, you can profit in several ways, as we saw in this article. But selling stock options could be an interesting strategy to get some extra income. When you sell stock options, you get some direct cash. This is in addition to the shares going up or down.

The other reason is to protect your existing assets. Many investors use stock options to protect themselves against future losses, either in a long position or a short position.

For instance, let’s say you have 100 shares of X, trading at 25 USD. You think that it will go up, but are also afraid that it may go down soon. So, you buy a put option with a strike price of 20 USD, expiring in two months, at 0.20 USD per share (20 USD total premium).

If, in two months, X is still trading higher than 20 USD, you have lost 20 USD in premium. However, if X has gone down below, you can sell your shares at the strike price and repurchase them cheaper. In that case, the maximum risk you are taking is the difference between the strike price and the current price (5 USD per share in that example).

Using a long call option can also be used to protect short position.

So, it is interesting to see how versatile stock options are.

Conclusion

To conclude, stock options are an interesting investing instrument. They can give you the right to sell or buy some shares later in time at a given price. Buying stock options can be a good way to realize a large profit with low risks. Selling stocks options are an interesting way of making some income, with potentially high risk.

You can use options for betting on a stock going up or going down. They are very versatile instruments.

However, options are also quite complicated, especially in their pricing.  I personally do not invest with options, and I do not intend to do so. In the short term, I believe they are an interesting investing instrument in hedging against risk. But stock options are advanced instruments, and most people should avoid them. I do not recommend trading with stock options. The long-term investor is better off with passive investing. But it is interesting to learn how they work.

If you want to learn about advanced strategies, short selling stocks is also very interesting.

I tried not to go too much into details in this article since it was an advanced subject. Would you want more details on stock options? And what about futures for the next installment.

Have you ever used stock options?