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 One way that investors can leverage a small amount of money to "play" in the market is via stock options. In this "beginner" article, we're going to talk about the two most common forms of stock options - the" put" and "call" options. With just two terms to help define what a stock option is, this might seem like a relatively simple explanation for a subject that can sometimes scare off new investors.
Understanding of Stock Options
If it helps a bit, here is another definition: A stock option is a contract giving the investor the right to either acquire or sell a stock at a future point in time at a set price. If you understand that definition, then you know all you need to know about the basic principles behind a stock option.
Stock Option Quotes
Stock options quoted in the newspaper or online are usually quoted in terms of 100 shares of stock. As previously mentioned, there are two basic forms of a stock option - a put or a call. In this publication, we're going to explain exactly what each of these terms mean, give a couple of examples, and finish up with a quick mention of the risks and rewards involved with this approach to investing in the stock market.
Put Options
When an investor purchases a put option, they are purchasing the right to sell 100 shares of the stock at a specific price on or before the option's expiration date. The price at which the investor can sell the stock is known as the exercise price or strike price. Selling the stock at the strike price is sometimes referred to as exercising a stock option.
Generally, an investor would purchase a put option if they believed that the price per share of the company is going to fall. This is the first of the two categories of stock option strategies as demonstrated in the following example.
Put Option Example
In this example, let's pretend the investor buys 1 put option of Company XYZ June $80. This gives the investor the right to sell 100 shares of Company XYZ for $80 anytime before the option expires in June.
If the price of Company XYZ were to fall to $50 per share, the investor in this put option can exercise their right, or option, to sell the stock at $80 even though the shares can be purchased at the $50 market price. This means the investor can realize a profit of $30 per share or $3,000 for the 100 shares sold.
Call Options
A call option is just the opposite of a put option. A call option gives the investor the right to purchase 100 shares of a stock on or before the option's expiration date. As is the case with put options, the price at which the call option shares can be sold is call the exercise price or strike price.
Generally, an investor would purchase a call option if they believed that the price per share of a company is going to rise. This is the second of the major stock options strategies as demonstrated in our second example.
Call Option Example
In this example, let's pretend the investor buys 1 put option of Company XYZ June $80. This gives the investor the right to buy 100 shares of Company XYZ anytime before the option expires in June.
If the market price of Company XYZ's stock were to rise to $100 per share, then investor in this call option can exercise their right to buy 100 shares of stock at $80 even though the shares now cost $100. This means the investor can realize a profit of $20 per share or $2,000 for the 100 shares purchased.
Using Stock Options to Forecast the Market
If we look at the stock market holistically, a large number of outstanding call options are a sign of optimism - investors are more inclined to believe that stock prices will increase. A larger number of put options is generally viewed as a more negative or bearish outlook on the market.
When purchasing either a call or put option, the investor is basically placing a bet that the market price of the company's stock will move away from its present selling price. A stock option is termed "in the money" when sufficient movement has occurred to allow the investor to sell the option at a profit. Options that are never reaching the point of being profitable are usually allowed to expire and the investor loses the price paid for the option.
Risk and Rewards Involved with Options
Buying stock options is considered taking a leveraged position in the market because the small price paid for the option itself gives the option holder the right to 100 shares of stock.
Listed below are some simplified rules outlining the risks and rewards undertaken when buying stock options:
- If you're the holder of a call option - sometimes referred to as the option holder - then your financial risk is limited. You cannot lose more than the premium paid since you always have the choice to "abandon the option."
- The potential gain on a call option is theoretically without limit since higher market prices for the stock translate into larger rewards for the option holder.
- If you own a put contract - sometimes referred to as the option writer - then the maximum financial risk involved can be limitless since the price of a stock is without theoretical limits.
- The maximum gain, or reward, to the writer of a put contract can be calculated based on the strike price times the number of shares involved. In this example, an option writer of a stock with zero value still has the right to sell the stock at the strike price.
Limiting Stock Option Risk
The risk of an option writer can be limited when taking what is termed a covered position. An option owner is considered covered if they actually own the underlying stock on which the option is written. When the seller or holder of a put option does not own the underlying stock, they are taking what is called a "naked position."
Stock options quoted in the newspaper or online are usually quoted in terms of 100 shares of stock. As previously mentioned, there are two basic forms of a stock option - a put or a call. In this publication, we will explain exactly what each of these terms mean, give a couple of examples, and finish with a quick mention of the risks and reward involved with this approach to investing in the stock market.
About the Author - Stock Options
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