What Are Stock Options?
Stock options are securities that offer investors a way to “bet” on the future price direction of a stock. Stock options provide the contract purchaser the right to buy or sell an asset a stock at a set price, on or before the expiration date of the contract. The contract seller agrees to fulfill the transaction. While the contract purchaser has the right to execute on the transaction, it is not an obligation. The purchaser may simply to choose to let the contract expire.
If the contract purchaser is convinced that a stock will either increase or decrease in a defined timeframe, the purchase of an option can enable them to profit from that price fluctuation.
Options can be used for speculative purposes or to protect against downside risk in your portfolio.
Types of Stock Options
Call Options (“Calls”) give the purchaser the right to buy a set number of shares at a set price before the expiration of the contract. The buyer of the call option wants the price of the underlying stock to rise within the period of the contract, while the seller either hopes that it will not. A call option is “in the money” whenever the market value of the underlying stock is above the exercise price of the option, and “out of the money” when the reverse is true.
An investor would buy call options on stocks (or another type of security) when they believe the price of the stock will increase beyond the exercise price of the option and cover their premium fee. If the call purchaser is wrong, they lose the fee for the premium.
Put Options (“Puts”) give the purchaser the right to sell shares at a set price. The buyer of the put option wants the price of the underlying stock to fall within the period of the contract, while the seller either hopes that it will not. A put option is “in the money” whenever the market value of the underlying stock is below the exercise price and “out of the money” when the reverse is true.
In offering the buyer the right to sell a stock for a specified price over within the timeframe of the contract, puts can also be used to limit portfolio risk.
The contract purchaser starts out with a net debit, meaning they have spent money they will not recover unless they sell the option at a profit. Any money they do make must have the cost of the option (the “premium”) deducted to arrive at the purchaser’s net profit.
The seller begins with a net credit because they have collected the premium from the contract purchaser. They profit is the premium if the purchaser never exercises the option. If the purchaser does exercise the option, the seller still keeps the premium, but must fulfill the transaction.
Stock options and your portfolio
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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