What Are Stock Options?
Isn’t it nice having options?
If you’re hungry, you have a wide variety of restaurants to choose from. If you want to buy a car, you have different makers producing different models with an endless array of upgrades.
It’s true that too many choices can sometimes cause paralysis by analysis, but having different options at our disposal allows us to weigh pros and cons and make informed decisions.
Traders have options too, and not just in the variety of different stocks and sectors to choose from.
Stock options allow traders the right to purchase a specific security at specific price at a specific point in the future – but not under any obligation.
Do you think a particular stock will be much higher in three months? Well, you can buy an option for that.
At the same time, another trader might look at the same security and see a drawdown brewing – and there’s an option you can buy for that scenario too.
Options give traders the opportunity to use leverage on their personal stock prognostications, but it’s important to understand how these types of derivatives work before putting them into practice.
How Do Options Work?
All options transactions involve two parties: a buyer and a seller (often referred to as the option writer).
The buyer is purchasing the right (but again, not the obligation) to buy a certain stock at a later date if a certain price is reached.
All option contracts have expiration dates, with some reaching out as far as multiple years. However, options can’t be held forever and the longer the time frame, the more expensive the contract will be.
If the buyer thinks a stock is currently undervalued, they might purchase a ‘call’ option in order to buy the shares cheaply after a large melt up. The buyer pays the option writer for the contract, which is known as the premium.
If you purchase an option and the underlying stock doesn’t reach the predetermined price (called the Strike Price), the contract will expire worthless.
If the stock does reach the strike price, the option will be ‘in the money’ (ITM) and the buyer will have the ability to purchase shares of the stock at the strike price, even if the shares have soared 60% above that price.
One contract gives the buyer the option for 100 shares, but the buyer doesn’t need to exercise the contract when the strike price is hit.
Options can be bought and sold on exchanges just like the underlying stocks themselves.
Calls vs Puts
A call option is a bullish bet on a stock. When buying a call option, a trader is betting that the underlying stock will increase in value.
If you think the rally in tech stocks will continue, you might purchase QQQ calls that expire in 3 months with a strike price 30% above the current QQQ share price.
Calls of this nature are ‘out of the money’ (OTM), meaning that they will expire worthless unless the underlying stock rises above the strike price by expiration.
If the stock price is above the strike at expiration, the call option will be ITM and the contract holder can buy (or ‘call’) 100 shares away from the option writer at the strike price.
As you can see, this exposes option writers to significantly more downside risk than option buyers. More on that later.
A put option is a bearish bet on a stock. Put options are purchased when the buyer thinks the underlying stock will decrease in value over a specific time period.
But unlike a call option, a put option gives the buyer the choice to sell a security at the predetermined strike price.
If a put option expires ITM, it means the stock has declined and the buyer will have the right to ‘put’ 100 shares on the writer at the strike price, collecting the difference in profit.
If you buy a $275 QQQ put and the share price is $250 at expiration, the buyer can sell 100 shares to the writer at $275 and buy back the shares from their broker at $250, collecting a profit on the difference.
Buying vs Selling Options
Buying an option means you are only risking your principal. If you purchase $500 worth of QQQ call options and hold through expiration while never reaching the strike price, you’re out your initial $500 and no more.
This goes for whether you’re buying calls or puts – you can only lose as much as you put in when buying options.
Selling an option is different though.
An option writer collects a premium when they sell the contract to a buyer.
In the example above, the buyer is paying the writer a $500 premium for the rights provided by the option contract. If the contract expires worthless, the buyer is out $500 and the writer pockets the premium.
Most option contracts will eventually expire worthless, but option sellers do open themselves up to potentially unlimited downside risk.
If a writer sells a call option right before a melt up rally in stocks, they might lose far more than the premium they collected – theoretically, the potential losses are infinite.
Because of this increased risk, most brokers only allow inexperienced traders to buy calls and puts. Gaining access to option selling usually requires more significant investing experience.
Differences Between Stocks and Options
Options are priced based on their underlying stocks, but the contracts are derivatives and offer no claim of equity like stock ownership does.
The first formula to price options is called the Black-Sholes formula, but today the majority of options on American exchanges are priced using the Binomial Pricing Model.
Option risk can be measured using four different factors, each named after a Greek letter in the alphabet.
- Delta – The primary Greek risk factor is the rate between the option price and the price of the underlying stock. Delta is often used for hedging since it supplies the number of shares needed to offset the option position (ie. delta of 0.6 means 60 shares of stock must be purchased to equal 1 put).
- Gamma – The rate of change between option delta and the underlying stock price. Gamma attempts to measure how much the option delta would move in relation to moves in the stock.
- Theta – All options have an expiration, which means they decay in value as that expiration date nears. Theta measures this time decay factor in relation to the option price.
- Vega – V stands for volatility. Vega measures the option price in relation to the volatility of the underlying asset. An increase in stock volatility won’t always affect an option in the same manner, hence the need for measuring Vega.
Options aren’t the most complex derivatives in the trading world, but understanding how they move in relation to their underlying stocks can take time to learn.
There’s a reason brokers limit the amount of options trading that newbies can perform – options involve leverage and making a mistake can cost you more than the value of your account.
Writing options is an advanced trading strategy not suited for those without experience or sufficient risk appetite.
Buying options involves less risk, but the volatility of derivatives might make certain traders uneasy.
However, if you’re a confident trader who wants to increase leverage without using margin, options can provide an avenue for the outsized profits you’re looking for.
Credit: Warrior Trading