An option is a contract between a buyer and seller that gives the buyer the right, but not the obligation, to either buy (call) or sell (put) the underlying asset at a predetermined price before a certain preset date. An option is a derivative security because its value is based on the value of another, like a stock, which is known as the underlying asset.
For stocks, the specified amount is in multiples of 100 shares. The specified price is known as the strike price, and the cutoff date is known as the expiration date. The cost to buy an option is called the premium, which is paid to the seller (also known as the writer) of the option.
The concept of buying and selling is identical to that of any financial instrument, like a stock. What may be a bit harder to grasp is that one can buy the right to buy or buy the right to sell. Conversely, one can sell the right to buy or sell the right to sell.
Options are a powerful tool in any investor’s toolbox because they can add value to a portfolio. They may be bought for speculative purposes or to mitigate risk and sold to generate income.
Calls vs. Puts
A call option for a stock gives the owner the right, but not the obligation, to buy a specified amount of the underlying stock at a specified price before a certain date. The seller (writer) of the option is obligated to sell 100 shares if the buyer exercises their right to buy.
A put option for a stock gives the owner the right, but not the obligation, to sell a specified amount of the underlying stock at a specified price before a certain date. The seller (writer) of the option is obligated to buy 100 shares if the buyer exercises their right to sell.
- One stock call option gives the holder the right to buy 100 shares of that stock, while one stock put option gives the holder the right to sell 100 shares of that stock.
- Call options increase in value as the underlying asset’s price increases.
- Put options increase in value as the underlying asset’s price decreases.
How to Trade an Options Contract
Trading options is similar to trading stocks in that the main decision is still a binary choice to buy or sell. The difference is that an options contract’s value is derived from the value of the underlying asset. This brings into play other variables, such as strike price and expiration date.
As is the case with trading any financial instrument, the first step is to find a way to place a trade. That means that an account that is equipped with trading options must be opened and funded. Because options trading is a bit more complicated, most brokerages tend to screen the account applications to gauge the applicant’s knowledge level.
When an account is approved, the process comes down to the decisions that the trader will have to make. The first decision is to select the type of option to trade: a call or a put. Next is the decision to be the buyer or the seller of that option. This is followed by the selection of the strike price and the time until expiration. Finally, after factoring in the premium costs that will be paid or collected, the trade is placed.
- If an investor thinks the price of the underlying asset will increase, then they will likely buy a call or write a put.
- If an investor thinks the price of the underlying asset will drop, then they will likely buy a put or write a call.
- If an investor thinks the price of the underlying asset will stagnate for a while, then they could write a put or a call and collect the premiums.
Understanding Expirations and Strike Prices
An options expiration date is the last date when the contract is valid. This is very important to both the buyer and the seller of that particular options contract. The buyer must decide if they want to exercise their right before this date. If they do so, then the seller has a responsibility to sell or buy the underlying stock to or from the buyer depending on whether it’s a call or put.
An options strike price is the price that the option holder would get if they exercised their right to either buy or sell the underlying stock. For example, a call option with a strike of $200 means that the option buyer and seller are contractually obligated to transact at this price if the buyer exercises their right. So, the buyer buys the stock at $200 and the seller sells the stock at $200.
- Generally, the more time that remains until a stock option’s expiration date, the more valuable the option.
- The expiration date for listed stock options in the United States is normally the third Friday of the month when the contract expires.
- The price difference between the underlying stock price and the option’s strike price is a key determinant of an option’s value.