A stock option is a contract that gives the buyer the right to buy or sell a stock at a fixed price in the future. Traders use stock options to trade the future value of a stock in the present.
A trader can buy a stock option which provides them the right to buy Alibaba (NYSE: BABA) stock at a price of $190 per share.
If the price rises to $300 per share, the trader can profit by using their stock option to buy shares at $190. They can then resell their stock on the open market at $300 to make a profit.
Calls and Puts
There are two types of stock options, calls and puts.
A call option provides the right to buy a stock at a future date at a fixed priced. While a put option provides the right to sell a stock at a future date at a fixed price.
As a general rule of thumb, people who buy call options benefit if a stock’s price rises and people who buy put options benefit if a stock’s price falls.
For everyone who buys a call or put option, there is another person selling them the call or put option on the other side of the trade.
If you sell a call option, you are selling to someone else the right to buy the stock from you at a fixed price in the future. If you sell a call option, you benefit if the stock price declines.
The same rules apply to sellers of put options except in reverse; a put seller is selling to someone else the right to sell the stock to them at a fixed price and the put seller benefits if a stock rises.
The table below highlights the different directional bets that can be taken with calls and puts.
How Stock Options are Valued
Stock options are not free.
Option buyers pay an option premium to the option sellers for the contract.
Option premiums are determined by market forces; in other words, what buyers and sellers are willing to agree on is a fair price for the option premium. However, sophisticated option traders will also use mathematical formulas to help inform them of the theoretical fair value of option premiums.
You don’t need to understand complex math to trade a stock option, there are many free tools provided by brokerage platforms or available online to assist in making the option premium calculations.
The heart of understanding how to value stock options is really understanding three key concepts: the stock option strike price, implied volatility, and contract expiration.
The stock option strike price is the fixed price that a trader agrees to buy or sell the stock at. For a call option buyer, if a stock trades above the strike price, then the option accrues value to the buyer. This is because they can use the option to profitably buy a stock at a cheaper price and resell it at the higher market price.
If a stock trades for a price where the option would be profitable, the option is said to be “in the money”. Conversely, if a stock trades for a price where the option would not be valuable, the option is “out of the money” and will be worthless at expiration.
Implied volatility is a key input for valuing a stock option.
Stocks that fluctuate more frequently and in a greater range are more volatile.
Implied volatility is a measurement of how volatile traders expect a stock to be in the future. The higher the implied volatility, the more expensive it is to by an option. This is because stocks that are more volatile are more unpredictable and have increased odds of making a large move upwards or downwards.
Option sellers will need more option premium to take a risk on a more volatile stock.
Time to Expiration
Finally, time to expiration is the number of days until an option contract expires. The longer the time to expiration, the more expensive the option contract.
This makes sense because an option is valuable and a rational person would be willing to pay more to have the option for longer.
These variables (strike price, implied volatility, time to expiration) and a few others (current stock price, interest rate, and dividend yield) all inform the value of an option; however, practically speaking a trader will be successful as long as they get the future stock price and expiration date correct.
If a trader gets the stock price or expiration wrong, their option may expire out of the money and be worthless.
Keep your investment journey going. Check out the related reading today to advance your investing knowledge and take control of your financial future!