A stock option is a contract that gives the holder the right, but not the obligation, to buy or sell a security at a specific price within a specific time frame.
This lesson will explain the world of stock options, how you can profit from options trading, and the differences between stock options and stocks.
What are stock options?
When granted a stock option, you are given the right to purchase shares of the company’s stock at a specific price, known as the strike price. The strike price is set when the option is granted and will never change.
Options are derivatives, meaning their value is derived from the value of another asset. In this case, the underlying asset is the stock of the company.
The price of the option is determined by several factors, including the price of the underlying stock, the strike price, the expiration date, and the underlying stock’s volatility.
Volatility is a measure of how much the price of a security fluctuates. A stock with high volatility is likelier to have a higher option price than one with low volatility.
Options are a leveraged investment, allowing you to control many shares with relatively little money. This leverage can lead to higher profits if the stock price moves in the direction you expect, but it can also lead to greater losses if the stock price moves against you.
How do stock options work?
There are two types of stock options: calls and puts. A call option gives you the right to purchase shares at the strike price, while a put option gives you the right to sell shares at the strike price.
The expiration date is also set when the option is granted and will never change. Options typically expire on the third Friday of the month they are granted.
If you choose to exercise your option, you must do so by the expiration date. If you do not exercise your option by the expiration date, it will expire worthless.
The strike price is the price at which you can purchase (or sell) shares of stock when you exercise your option. The strike price is set when the option is granted and will never change.
The expiration date is the date on which your option expires. If you do not exercise your option by the expiration date, it will expire worthless. The expiration date is set when the option is granted and will never change.
If the stock price is above the strike price when the option expires, then the option is said to be “in the money.” If the stock price is below the strike price when the option expires, then the option is said to be “out of the money.”
When you exercise a call option, you purchase shares of the underlying stock at the strike price. When you exercise a put option, you sell shares of the underlying stock at the strike price.
If you hold an in-the-money option at expiration, you will automatically exercise your option and take possession of the shares (or cash) you are entitled to. If you hold an out-of-the-money option at expiration, your option will expire worthlessly, and you will not receive anything.
Employee stock options
Stock options are often used as a way to attract and retain employees. For example, a company might offer its employees the option to purchase shares of its stock at a discounted price. The employees can then exercise their options and buy the stock at a discounted price, even if its value has increased.
Incentive stock options
There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). ISOs are typically only available to employees, while NQSOs can be awarded to anyone.
ISOs have special tax benefits that NQSOs do not. For example, when you sell ISO shares, you may qualify for long-term capital gains treatment if you hold the shares for more than one year after exercising your option and two years after the grant date. This can result in significant tax savings.
NQSOs are not subject to the same rules as ISOs. When you sell NQSO shares, you will be taxed at your ordinary income tax rate on any profit (the difference between the sale price and the option strike price).
Stock options can be a valuable addition to your compensation package. If you have been awarded stock options, it’s important to understand how they work and what your tax obligations are. Consult with a financial advisor or tax professional to learn more.
Stock option trading
When it comes to trading stock options, there are a few things that you need to keep in mind. For one, you need to be aware of the risks involved. Trading stock options can be a very profitable venture, but it can also lead to substantial losses if you are not careful.
Another thing to remember when trading stock options is the time frame you want to trade. Options can be traded on a short-term basis or a long-term basis. Short-term options typically expire within a few months, while long-term options can last for years.
Finally, it would help if you understood how stock options work before you start trading. Stock options give you the right to buy or sell shares of a particular stock at a set price. The strike price is when you can buy or sell the stock.
If you think the underlying stock price will increase, you want to buy a call option. If you think the underlying stock price will decrease, you would want to buy a put option.
Once you have decided which type of option you want to buy, you must find a broker that offers options trading. Options are not commonly traded on major exchanges, so you may need to look for a broker specializing in options trading.
Once you have found a broker, you must open an account and deposit funds. Once your account is funded, you can start trading stock options.
Starting with small trades may be a good idea if you are new to stock options trading. This will allow you to get a feel for how the market works and how stock options work. As you become more comfortable with stock options trading, you can increase the size of your trades.
What is a call option in stocks?
A call option is a type of financial contract that gives the holder the right, but not the obligation, to buy a security or other assets at a set price within a certain time frame. The price is typically set at a fixed premium above the underlying security’s market price. Call options are commonly used as a speculative investment to bet on an asset’s future price movements. For example, let’s say you buy a call option on ABC Company stock with a strike price of $50 and a premium of $2 per share.
This means you have the right to buy 100 shares of ABC stock at $50 per share anytime in the next two months. If the stock price rises above $52 ($50 strike price + $2 premium), you can exercise your option and make a profit. If the stock price doesn’t rise above $52, you can let the option expire worthlessly and only lose the $200 you paid.
Options are a derivative, which means their price is derived from the price of an underlying asset. In this case, the underlying asset is ABC Company stock. Call options are one type of stock option and are considered “long” positions because you want the stock price to increase.
What is a put option in stocks?
Put options are the other type of stock option and are considered “short” positions because you want the stock price to go down. When you buy a call option, you’re paying a premium for the right to buy shares of the underlying asset at a set price. The strike price is the price at which you can buy the stock, and the expiration date is when the option expires. The premium is the price you pay for the option itself. It’s important to remember that you’re not obligated to buy the shares if you don’t want to. You can let the option expire without exercise and only lose the premium you paid for it.
How can you profit from stock options?
There are a few different ways to make money from call options. The most common is to buy the option and hope the stock price goes up so you can exercise the option and buy the shares at a lower price than they’re currently trading for. You can also sell the option before it expires, known as “closing your position.” You can sell the option for a profit if the stock price goes up. If the stock price goes down, you’ll lose money.
Another way to make money from call options is to sell them. This is known as “writing” or “selling” a call option. When you write a call option, you give someone else the right to buy shares of the underlying asset at a set price. You’re also collecting a premium for giving them this right. If the stock price doesn’t exceed the strike price, you keep the premium, and the option is worthless. But if the stock price goes up, you’ll have to sell your shares at the strike price, which means you could miss out on some profits.
There are a few different ways to make money from call options. The most common is to buy the option and hope the stock price goes up so you can exercise the option and buy the shares at a lower price than they’re currently trading for. You can also sell the option before it expires, known as “closing your position.” You can sell the option for a profit if the stock price goes up. If the stock price goes down, you’ll lose money.
What does it mean to exercise stock options?
When you exercise your stock options, you buy the underlying stock shares at the strike price. This means you must purchase the shares at a price set by the option, regardless of how much they may be worth on the open market.
When to exercise stock options
There is no one answer to this question, as it depends on various factors, including the stock options plan, the current market conditions, and your financial situation. Typically, you will want to exercise your stock options when they are “in the money,” meaning that the underlying stock’s current market value exceeds the options’ strike price. However, you may also want to consider other factors, such as your tax situation and whether you plan to sell the shares soon.
The best stocks for options trading
The best type of stock for options trading are stocks that are considered more volatile, as they can provide greater profits but also pose a higher risk. Conversely, less volatile stocks may not provide as much profit potential but may be less risky.
Ultimately, it is up to the individual investor to decide what type of stock is best for their portfolio and investment strategies.
Five risks and benefits of trading stock options.
Regarding trading stock options, there are several risks and benefits to consider. Here are the top 5:
1. Risk: The biggest risk of trading stock options is that you can lose money if the stock price moves against you. This can happen if you buy a call option and the stock price falls or sell a put option and the stock price rises.
2. Benefit: The benefit of trading stock options is that you can make money if the stock price moves in your favor. This can happen if you buy a call option and the stock price increases or sell a put option and the stock price decreases.
3. Risk: Another risk of trading stock options is losing money if you don’t time your trade correctly. For example, if you buy a call option and the stock price falls after purchasing it, you will lose money on the trade.
4. Benefit: A benefit of trading stock options is their flexibility. For example, if you think a company’s stock will go up but don’t want to commit to buying the shares outright, you can buy a call option instead.
5. Risk: One final risk is that stock options are a leveraged investment. This means that you can control a large number of shares with a relatively small amount of money. While this can lead to large profits if the stock price goes up, it also means that losses can be magnified if the stock price falls.
Overall, there are both risks and benefits to trading stock options. It’s important to understand these before deciding whether or not to trade.
PODCAST – Stock Options Trading Top 11 Tips
How Stock Options Trading Works. Included are my Top 11 Tips and Mistakes to avoid.
- Published: Sun, March 25 2018 23:00:00 GMT
- Duration: 00:09:54
- Related Article – Top Stock Options Tips
Stock Options vs. Stocks
Options are simply a contract; you do not own the underlying stock that determines the value of your options contract. Unlike stocks, you can hold options indefinitely. Options contracts all have an expiration date, and the closer to the expiration date you get, the less your option is worth.
As you do not own the stock, only a promise to pay the difference between the stock price now and at some point in the future, you will see that the options contracts cost as little as 2% to 20% of the cost of owning the stock.
Stock Options are simply a vehicle to achieve a goal. For those who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.
The main difference between buying stocks and buying stock options is that with options, you have the right, but not the obligation, to buy or sell a certain number of shares of the underlying stock at a set price (the strike price) on or before a certain date (the expiration date). If you buy stock options, you are betting that the underlying stock price will increase. If it does, you can exercise your option to buy the stock at the strike price and then sell it immediately at the higher market price and pocket the difference. If the stock price goes down instead, you let your option expire worthlessly and lose only the premium you paid.
With stocks, on the other hand, you are buying a piece of ownership in a company and hoping that the stock price will go up so you can sell it at a profit. If the stock price goes down, you can still sell it, but you will take a loss.
However, there is one major advantage to buying stocks over options: with stocks, you can earn dividends, which are not paid out on options. Dividends can provide a nice stream of income.
The best way to understand options is to run through an example.
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Stock vs. Stock Options: 3 Strategies Compared
For example, you have $1,000 to invest.
Strategy 1 – Buy the Stocks
You could buy five shares of Amazon Inc. (Ticker: AMZN) at $200 per share.
Total Costs: $1000
If Amazon moved up 10% over the next two months to $220, your profit would be
($220 – $200) = $20 per share. 5 Shares * $20 = $100
A 10% gain.
Strategy 2 – Buy Options on the Stock
You could buy one “At the Money Call Contract” for AMZN with a strike price of 200 and an expiry date of May 21, 2013. The contract value is $10 per share. Because you will control 100 shares with each contract and buy one contract, your costs for the trade are $1000.
In options speak:
- One contract means you will have control over 100 shares of AMZN
- At the money means the strike price of $200 per share equals the actual stock price.
- The strike price is the point at which the option will have a value (apart from the time value)
- The expiry date is when the option contract expires and loses all value.
In the same scenario, the stock price moves 10% to $220. The price difference is $20 per share. The contract was at a strike price of $200; therefore, $220 – $200 = $20 profit per share.
Theoretical profit would be 100 * $20 = $2000, a $2000 gain from a $1000 investment. This means a gain of 100%.
I say theoretically because the clock starts ticking on the time value when you buy an option. If the stock price took until the final month before expiry to move to $220, you would have lost all of the time value of the contract, which could reduce your profits. However, if the stock had moved 10% in a single day, you would have secured almost all of the 100% and kept much of the time value in the stock.
What are the risks of options compared to simply buying the stock?
You can lose the entire investment if the stock price moves against you. With stocks, this is quite rare; stocks rarely move to zero unless the company goes bankrupt.
If the stock price does not move in the period, your investment can also expire worthlessly.
The stock needs to move in the direction you place the bet to make a profit. If the stock price moves sharply, your earnings can be quite large.
Strategy 3 – Shorting stock using options
Using the same scenario, we expect the stock to increase in value instead of expecting it to decrease.
AMZN has a current stock price of $200
You could buy one “At the Money Put Contract” for AMZN with a strike price of 200 and an expiry date of May 21, 2013. The contract costs $10 per share, and are 100 shares in a contract. The cost of investment is $1000.
In options speak:
- One contract means you will have control over 100 shares of AMZN
- “At the money” means the strike price of $200 per share has already been reached.
- The strike price is the point at which the option will have a value (apart from the time value)
- The expiry date is when the option contract expires and loses all value.
In this scenario, the stock loses 10% in value to $180. The price difference is now $20 per share. The contract was at a strike price of $200; therefore, $200 – $180 = $20 profit per share.
The theoretical profit would be 100 * $20 = $2000. This means a gain of 100%.
Options Summary
Options are complex instruments, but the more you understand them, the more they make sense. With experience, you will see that they are an incredibly flexible investment tool. However, before considering trading options, you must understand how to pick stocks, evaluate market direction, and formulate a strategic, systematic approach to investing.
To succeed at stock options trading, you must have a solid understanding of the market. It would be best if you also were patient and disciplined. Stock options trading can be a very profitable way to make money, but it takes time and effort to succeed.
