Stock Options: Understanding How They Work

Stock options are the rights to buy and sell stock by a certain date for a particular price. Knowing that is only the beginning. Let’s take a quick look at how they actually work. If you were interested in a company and thought the price was likely to go up you could buy a call option on the stock to guarantee you the right to buy the stock at the current price anytime in the future up to the expiration date. You will pay a premium to reserve this right to buy.

So, for example XYZ Corp. is trading at $25 per share and the premium on a call that expires in 6 months to lock in $25 per share is $4 per share. Since an options contract is for 100 shares of stock you would pay $400 plus broker’s fees to purchase a contract. By doing that you are betting that the stock will rise in price above $29 per share ($25 strike price + $4 premium price). If that happens at any time during the contract’s time frame you can then strike the contract, pay the $2500 for the shares and ‘call’ them away from their owner. With stock options you are buying time without having to tie up all your capital in the purchase waiting for the price to appreciate. If the stock does not reach your minimum invested price then it would not be in your best interest to strike the contract and you would allow it to expire worthless.

As well, since you own the contract you can sell it at any time to someone else. Stock options trading is governed by more variables than the stock itself and the value of the contract is subject to decay in value over time. The Premium you paid is a function of the time to expiration, the difference between the stock price and the strike price of the contract, market volatility and other factors. But, in general, if you own a contract with a long time to expiration then the value of the contract will rise and fall with the price of the stock. This presents trading opportunities if you are so inclined.

Buying calls is a bullish strategy. Selling put contracts is the converse, the right to sell at a price before a certain date, and is a bearish strategy. In both cases buying the contract defines your risk in the transaction. You have committed these funds to the trade and no more. That is the biggest advantage to stock options trading, using leverage and time to maximize your gains while explicitly defining your risks. 90% of all option contracts written expire worthless.