What Is a Stock Option?
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.
- Expiration Date
- This is the date an option contract expires. After this date, you no longer have the right to buy or sell the underlying stock.
- Strike Price
- This is the set price at which you have the right to buy or sell the underlying stock. It’s also referred to as the exercise price.
- Contract Size
- A stock option contract doesn’t pertain to a single underlying security. Each contract represents 100 shares of the underlying stock. If the contract is executed, you must buy or sell 100 shares.
- Premium
- This is the cost of an option contract. It’s the amount of cash needed to acquire the right to buy or sell the underlying stock.
- Exercising
- This term describes the act of executing the right embedded in an option contract. Exercising an option contract triggers either the purchase or sale of the underlying stock.
- American-Style Option
- This type of options contract is one that can be exercised at any time prior to its expiration date.
- European-Style Option
- This type of options contract is one that can be exercised only on its stated expiration date.
Key Terminology
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Types of Stock Options
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.
A special type of call option is an employee stock option. This form of compensation that some companies — including many startups — offer to their employees to retain and reward them involves giving employees the option to purchase a certain number of shares of company stock at a set price for a defined amount of time.
How Do Stock Options Work?
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.
Call Option Example (Speculative Strategy)
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.
Call Option Profit =
(Stock Price at Exercise – Strike Price – Cost per Option) x Contract Size x Contracts
Call Option Profit = ($75 – $55 – $2) x 100 x 1 = $1,800
Put Option Example (Risk Hedging Strategy)
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:
Put Option Profit =
(Strike Price – Stock Price at Exercise – Cost per Option) x Contract Size x Contracts
Put Option Profit = ($80 – $40 – $3) x 100 x 2 = $7,400
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).
Frequently Asked Questions About Stock Options
The determination of the value of a stock option is dependent on a handful of variables, including the price of the underlying stock, the volatility of the underlying stock and the time until expiration. Computations vary, depending on the model employed. The most well-known pricing model is called the Black-Scholes-Merton Model.
Stock options are not inherently better than stocks, but they offer investors the ability to establish bullish and bearish positions in a risk-minded way without fully committing themselves financially.
Yes, you can sell stock options. Selling options, commonly known as writing options, gives an investor the ability to earn premium income rather than paying it. However, the downside risk for sellers is much greater than it is for buyers.
