Stock Options

A stock option is a type of derivative financial instrument. It is known as a derivative because its value comes from (or is derived from) an underlying security — a stock. Essentially, it’s a financial contract that gives the option holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price for a specified period‌.

This optionality comes at a cost, but it’s generally modest when compared to the commitment and downside risk associated with the actual purchase or short sale of a stock. Therefore, stock options appeal to many speculative investors. They are also popular with people looking to hedge existing exposures.

Note that we largely focused this article on long option positions, which refer to the buy-side of call and put option trades. However, you can also establish short option positions, which refer to the sell-side of these trades.

So far, we’ve outlined the characteristics of a stock option fairly holistically. However, there are actually two distinct types of stock options.

A call option is a financial contract that gives the holder the right — but not the obligation — to buy a named stock at a set price during a specified period‌. The buyer of a call option expects the price of the underlying stock will increase. If this occurs, he or she stands to profit.

A put option is a financial contract that gives the holder the right — but not the obligation — to sell a named stock at a set price during a specified period‌. The buyer of a put option expects the price of the underlying stock will decrease. If this happens, he or she stands to profit.

Stock options can be difficult to understand, especially for people that have never spent time studying or trading these securities. The numeric examples that follow provide some clarity.

Assume you believe Stock ABC, which is currently trading at $50 per share, has the potential to experience a significant price increase over the next 30 to 60 days. You don’t have the cash to buy the stock outright, but you want exposure to it.

You decide to buy a 60-day, American-style options contract with a strike price of $55. The cost of the contract is $200, which equates to $2 per option, given a standard contract size of 100 options ($200 ÷ 100 options per contract = $2 per option).

After 45 days, the price of the underlying stock has shot to $75, validating your analytic intuition and putting you in a profitable position. You don’t think the stock is likely to increase substantially over the next 15 days. So, you decide to exercise the option contract and realize your profit.

Assume you own 200 shares of XYZ Corporation, and it’s currently trading at $85 per share. You feel fairly comfortable about the long-term viability of the company, but you are worried it could face severe downside volatility over the next 90 days. You don’t want to sell the stock, but you also don’t want to leave yourself exposed to a sharp price decline.

The solution is to buy put options on XYZ corporation, effectively putting a floor on the price of your stock. You implement the strategy by buying two 90-day, American-style options contracts with a strike price of $80. The cost of the two contracts is $600, which equates to $3 per option, given a standard contract size of 100 options ($600 ÷ 100 options per contract ÷ 2 contracts = $3 per option).

After 85 days, the price of the underlying stock has plummeted to $40, proving the validity of your anxiety. With only five days left until the expiration of your contracts, you are ready to exercise the puts. Doing so produces the following profit on the options trade:

Don’t forget about your exposure to the XYZ stock. You lost $9,000 on the decline in the value of your 200 shares when it fell from $85 to $40. Fortunately, thanks to the shrewd options hedge, your aggregate loss was limited to $1,600 ($7,400 – $9,000 = –$1,600).