Stock options are powerful tools that can be used to generate outsized gains or losses relative to their costs. For instance, you could buy 100 shares of XYZ Corporation at $50 each, or $5,000. If the price doubles to $100 a share, your profit is 100 percent. If instead you purchased a call option for $5 with a $50 strike price, you would make almost a 1,000 percent profit. If instead the stock fell below $50, your call option would expire worthless. With options, timing is everything.
Calls and Puts
A call buyer has the right to purchase 100 shares of a stock by a given expiration date at a preset purchase price, or strike price. For this privilege, the buyer must pay a premium to the seller. The seller is obligated to deliver the shares at the strike price should the buyer decide to execute the call before it expires. A put is similar except that it gives the buyer the right to sell 100 shares at the strike price, a strategy that benefits from falling stock prices. If the stock price falls below the strike, the put seller may have to purchase the 100 shares from the put buyer.
You buy a call option if you think the stock price will shoot up before the option expires. Assuming you already are focused on a particular stock, you have two decisions to make. The first is strike price. The price you pay for an option depends on the relationship between strike price and stock price. If you want to buy an option that gains the same value as the underlying stock when the stock rises, you buy a call that is deep in-the-money, which is when the strike price is well below the stock price. In-the-money options are the most expensive, and this strategy is favored by someone who is relatively risk averse. If instead you wish to take a "long-shot," you buy deep out-of-the-money calls, in which the strike price is well above the stock price. These options are very inexpensive, but if the stock price rises significantly, these options will explode in value. This is a very risky purchase. The last choice is buying at-the-money, which is when the strike and stock prices are about the same. It is used by someone who wants to take a moderate risk. The call price will go up at about half the rate of the stock, but that ratio will increase as the call becomes deep in-the-money. All the same considerations pertain to a put option, except you buy a put when you expect the stock price to go down.
Now that you have selected a strike price, your second decision is to determine which expiration date to pick. Most stock options have quarterly expiration dates. Depending where you are in the cycle, you can buy an option with an expiration ranging from one day to one year. The cost of an option increases as the expiration period lengthens. Purchasing long expiration dates gives your underlying stock more time to make a large price move. Short-dated options are risky.
You might be motivated to buy a particular stock option if you think that the option is underpriced. Option prices are determined by a pricing formula but are subject to supply and demand. If you feel that a particular option is cheaper than it should be, you can buy it and hope the price returns to "normal." Another reason to buy an option is to hedge a stock position you already own. If you own 100 shares of XYZ stock, you can buy an at-the-money put that will protect you should the share price decline. The price of the insurance is the cost of the option. The put will only protect you until it expires.
Video of the Day
- Options for the Beginner and Beyond: Unlock the Opportunities and Minimize the Risks; W. Edward Olmstead
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