These contracts are referred to as options because they give the contract owner the right but not the obligation to exercise the contract.
Investors often use options to enhance their investment portfolios. They can be used to protect an investment position if the market goes into a downturn, or they can provide additional income if it’s believed that the market may rise. This all depends on the investor’s options strategy, the prices of the contracts, and where the market actually goes next.
How Does Options Trading Work?
An options contract consists of several important components:
- Underlying security - The equity named in the options contract (such as a stock).
- Holder - The buyer of the options contract.
- Writer - The seller of the options contract.
- Option type - Options can either be classified as calls or puts. A call gives the option holder the right to buy a stock whereas a put gives the holder the right to sell a stock.
- Strike price - The price of the underlying security that the call or put can be exercised. Note that in the options market, there will be a range of strike prices to choose from.
- Expiration date - The date at which the option expires. If the market reaches the strike price, then the option holder may exercise it. If it doesn’t, the option may expire worthless.
- Premium - The price that the option holder pays the writer for the contract. The price is composed of the sum of its intrinsic value (the price difference between the current price and strike price) and its time value (the time between now and the expiration date).
Types of Options Contracts
Options trading is essentially placing a bet on where you think the price of the underlying security will go next. Investors already inherently do this when they hold or short a stock. However, they can further enhance their portfolio by also incorporating options. Here are a few simple examples of how calls and puts can be used.
Call Option Example
Let’s assume ABC stock is currently trading at $100 per share. You believe that the stock will go up and so you buy a call option at $105 per share.
A month goes by and the stock price goes up to $115. Because you have the option to buy at $105, the option writer must sell you the shares at this price. You’ll make a profit of $10 per share ($115 minus $105) excluding the cost of the premium. The seller, on the other hand, misses out on this gain and only gets $5 per share ($105 minus $100) plus the premium.
Alternatively, let’s suppose that the market went down instead and ABC stock drops to $90. In this case, you don’t have to exercise the option because it would make more sense to buy the stock in the open market ($90) for cheaper than the strike price in the option ($105). Therefore, the option would expire worthless and the holder would only lose the premium they paid for it. The seller, meanwhile, takes no action and gets to pocket the premium.
Put Option Example
A put is basically the opposite of a call option.
Let’s again assume ABC stock is currently trading at $100 per share. This time, you fear the market will crash and that your stock will drop in price. To protect your investment, you purchase a put option to sell ABC stock at $95 per share.
A month goes by and the stock does in fact drop to $85 per share. As the holder of the put option, you can exercise your contract and the seller is obligated to buy your shares at $95. That means your loss is only $5 per share ($100 minus $95) instead of the actual $15 per share loss. Meanwhile, the writer of the put option would lose $10 per share ($95 minus $85)
Alternatively, let’s suppose that the market went up instead and ABC stock rises to $110. In this case, you don’t have to exercise the option because it would make more sense to sell your stock in the open market ($110) for greater than the strike price in the option ($95). Therefore, the option would expire worthless and the holder would only lose the premium they paid for it. The seller, meanwhile, takes no action and gets to pocket the premium.
What are Options Used For?
Options can be used as investment instruments in several ways. Here are a few common purposes.
Insurance
Options can be thought of as insurance policies for investors. By having the ability to sell an underlying security at a known price, the investor doesn’t have to risk losing its full value. This is similar to how a vehicle owner purchases auto insurance to recoup the value of their vehicle if they are involved in an accident.
Speculation
Investors who believe a stock will fluctuate in price can capitalize on the opportunity. For instance, they can use a call option to capture it at a lower strike price if they believe the market price will climb. Alternatively, if they believe the market will go down, they can use the put option to lock in at a specific strike price and capitalize on the seller’s loss.
Profit
Options give investors the ability to earn some extra money on changes in market prices. For example, they could sell an option and collect the premium regardless of whether it is exercised. Investors can also profit from options trading without even necessarily holding the underlying securities they represent.
Can Anyone Trade Options?
Technically, options trading is open to all investors. However, the process is not as straightforward as buying and selling stocks. There are specific rules and expiration dates involved with these contracts, so it requires more attention than regular equity trading.
For this reason, most financial professionals consider options trading an advanced strategy. Therefore, many investment platforms will screen the abilities of their clients before allowing them to trade options outright.
The Bottom Line
Options trading is the use of contracts to buy or sell securities at a specific price. Options can be used to protect against potential losses, capitalize on price fluctuations, and earn additional profit. However, due to its specific usage and speculative nature, it's critical that investors only use options trading if they fully understand and appreciate the risks involved.