What Are Options?
Options are contracts that guarantee the purchase or sale of a certain security within a certain window of time. Options are divided into two categories based on the nature of the contract.
When an investor wants a guarantee to the right to purchase a stock, the option is known as a call option. When an investor wants to purchase the right to sell a stock, it is known as a put option.
In the case of either the call option or the put option, the purchase doesn’t just include the right to buy or sell. It also includes the right to sell at a specific price, known as the strike price, and to do so within a specified window of time.
How Stocks Impact Options
In the world of options, stocks are referred to as “underlying securities.” Options are contracts, and while they may be valuable in their own way, they are dependent on the behavior of the stock in question—the underlying security.
An investor who purchases a call option (the right to purchase) benefits when the price of the underlying security goes up. Because a call option grants the right to purchase at a specified strike price, that investor can “call in the stock” at a price that is lower than the current market price.
If an investor purchases a put option (the right to sell), then he or she benefits when the price of the underlying security goes down. A put option allows an investor to “put the stock back on the market” at a price that is higher than the current market price.
What this means for investors, in theory, is that profit from options trading comes from the exercising of the option—either purchasing or selling at a specified strike price.
A call option is purchased for stock ABC, which is currently trading at $150. The strike price of the call option is $151.
Stock ABC’s value climbs higher than $151 before the option expires. Within a day, it is valued at $155.
The owner of the call option can call the stock in at the strike price of $151, then immediately resell the stock at the current market price of $155 in order to realize a profit.
This example illustrates how an investor profits from an options trade—in theory.
In practice, however, most options contracts are resold to another buyer before they are exercised. Options traders make their profits by buying an options contract and then selling it at a higher price.
Profiting Through Options Trading
Options contracts are not free.
Investors pay to own the option contract. This means that in order to profit, not only does the value of the underlying security need to move in the right direction, it must also move far enough for the buyer to recover the price paid to own the option.
Stock ABC from the previous example is trading at $150.
An investor purchases a call option contract entitling that person to buy 100 shares of ABC stock at $151 per share within a time period of one week from the date of purchase.
The price to own this option (often referred to as the “premium”) is $1.89 per share. This makes the total premium on a 100-share contract $189.
Due to the added expense of the contract’s premium, a profit from exercising the option may only be realized if the price of ABC stock climbs above $152.89 per share, or the strike price plus the premium on each share.
Once this threshold is reached, the option is considered to be “in the money.”
From our previous example, a stock price of $155 would mean that the investor could call the stock at the strike price, sell it at the market price, and make a profit of $2.11 per share.
Remember, options contracts can only be exercised within their specified time periods. Were the stock to increase to $155 nine days from the date of the call option purchase, the owner would be out of luck.