Understanding Stock Options

stock optionsIf you’re at all familiar with investing, then you probably understand how a stock works, at least in broad strokes. When you buy a stock, you buy a share in a company. It’s not a literal ownership share (there are some legal differences), but it’s pretty similar in some ways. If the company does well, the value of your stock goes up. If the company does poorly (at least relative to what its expectations were), then there will be less demand from people who would buy your stock, and the stock will lower in value. That’s simple stuff — it’s really just a stock-market version of supply and demand!

But what about options? A “stock option” is something that you might hear about when a company tries to hire you. Or you might hear about someone using options to “short” a stock. What does this mean? Let’s explore the fascinating world of stock options.

What is an “option?”

When we talk about “options” in the stock market, we’re talking about options contracts. Options contracts are agreements between two parties that stipulate that one party may — but does not have to — buy from or sell to the other party a investment at a given price. For example, the contract may say that you have the right to buy 100 shares of CompanyCorp stock from me, at $4.21 per share during a certain time period. (Why 100 shares? Because options contracts virtually always offer options on shares in multiples of 100.)

Let’s say that the CompanyCorp stock is currently trading at $4.20 per share. You’d be better off buying it on the open market than from me, even though you could buy it from me if you wanted to. But if the stock surges to $4.81 a share, all of a sudden you stand to make a ton of money. You can exercise your option, buy 100 shares from me at $4.21 a pop, and turn around and instantly sell them on the open market for $4.81 each, turning a nice 60 cent-per-share profit. Sixty bucks! Well, it’s not very much, but this is just an example.

But wait — how do I benefit? You have all the power, and I have none. Well, in this example, it would have been me who issued the option. I sold the options contract to you, and I made money when you bought it. I must have thought that CompanyCorp was a lousy bet — I figured their stock would fall in value, so you wouldn’t be keen to buy it at $4.21 in the time period before the contract expired. I was wrong, and now my loss is your gain — though whatever you paid for the option will cut into your profit of $60.

Call options vs. put options

There are two basic types of options contracts: call options and put options.

A call option is the one that we covered in our example. When you purchase a call option, you’re buying the right to buy a certain investment at a certain price during a certain time period — but you don’t have to buy it if you don’t want to. When you offer that option to someone else, you’re promising to sell that stock to that person at that price if they choose to exercise the option.

A put option is the opposite. When you buy a put option, you buy the option to sell some other investor a given investment at a given price in a given period of time. When you offer someone else this, you’re promising to buy their junk if they exercise the option, even if the price is not too attractive when that day comes (and if they’re exercising the option, you had better believe that you won’t like the price).

The call vs put distinction is important, because investors use one or the other to show whether they are bullish (optimistic) or bearish (pessimistic) on the future of a stock or other investment.

Using options to make bets on the market

You can use options in all sorts of ways. Some are riskier than others, but all are a bit more advanced than a typical buy-and-hold strategy.

Maybe you own the stocks that you’re selling options on — but maybe you don’t, which can be risky. If you’re “short” a stock and sell a call option, you’ll maximize your profits if the stock goes down. You’ll have made money on your option, but you won’t lose anything when the stock plunges, because you don’t own it (and the person who holds your option won’t want to buy the stock at that price). But if the stock goes up, watch out! You’ll have to buy it on the open market in order to fulfill your obligation, and you’ll be forced, of course, to sell it at the contract price — that is, for a loss.

Options can be tricky, but with some know-how and some care, you can master them and make them a valuable part of your trading strategy.

Shift Frequency © 2018 – Educational material

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