A stock option is a contract that gives the owner of the option the right, but not the obligation, to buy or sell 100 shares of a particular underlying stock at a specific price, also known as the strike price, before the option’s expiration date.
Stock options are listed on exchanges such as the Chicago Board Options Exchange. Individual investors can benefit from buying and selling stock options in pursuit of this opportunity.
Individual investors should know the difference between American options and European options. American options can be exercised anytime between the purchase of the option and the expiration date, while European options only can be exercised on the expiration date.
American options are the most common variety. Regardless of which type of option an investor uses, trading options entails accepting risk in pursuit of potentially large profits.
Let’s get into some of the basic rules of stock option trading and then tie all the rules together with a couple examples.
Rules of Option Investing
Buying a stock option requires paying a premium. If the premium of an option is $0.20, then the option contract will cost $20. This is because one option contract equals 100 shares of a company’s stock (100 x .20 = 20). In this scenario, the buyer of the option would pay the $20 to the seller of the option; the buyer and seller are otherwise known as the holder and writer of the option.
The holder of the option has the right to exercise his option but is not obligated to do so. However, if the holder does exercise his right and buys or sells 100 shares of the underlying stock within the expiration date, then the writer of the option is obligated to either buy or sell the shares of the stock to the holder.
The holder of a call option has the right to exercise the option to buy 100 shares of stocks. He would purchase a call option if he expects the market value of the company’s shares to increase.
The holder of a put option can exercise his right to sell 100 shares of stock to the writer of the option. An investor would purchase a put option if he expects the price of stock to decrease.
For the writer of a call or put option, a profit can be collected in the form of premium paid by the buyer of either option. The writer of a call option would expect the market value of the related stock to go down. The writer of a put option would expect the market value of the related stock to go up.
Here are two examples.
(1) The perspective of a call option holder: The Walt Disney Company (NYSE: DIS) stock is trading at $100. You buy a call option for DIS because you have faith the stock is going to rise in value. The strike price of the option is $102 and the expiration date is in one month. You pay a premium to the option writer of $1 per share, or a total of $100 per contract. Imagine within that month, the price of DIS stock goes up to $105. The call option holder then can exercise his right on that option and BUY 100 shares of DIS at $102 from the option writer. The holder of the call option then immediately can sell those 100 shares at the market price of $105 to produce a profit of $3 per share, or $300. The call option holder previously paid a $100 premium to reduce his total profit to $200. If the DIS stock didn’t go above $102 within the month, then the call option would expire worthless; the writer of the option would keep a profit of $100.
(2) The perspective of a put option holder: Apple (NYSE: AAPL) stock is trading at $180. The put option holder buys a put option for AAPL because he expects that the stock is going down in value. Assume the strike price of the option is $177 and the expiration date is in three weeks. The put option buyer pays a premium to the option writer of $1 per share, or $100 for the contract. Within those three weeks, the price of AAPL stock goes down to $175. The put option holder then can exercise the put option and buy the AAPL shares at $175 but immediately SELL them at $177. This generates a profit of $2 per share, or $200. After paying the $100 premium, the put option holder can keep a profit of $100. If the AAPL stock did not fall below $177 within the three weeks, then the put option would expire worthless; the writer of the option would retain a profit of $100.
The preceding examples show the full picture of what it’s like to be the holder or writer of a stock option and how to profit either way. To learn more about options trading and certain strategies to generate even more profits, click here.