A stock option contract guarantees you a specified “strike price” for a limited time. If it’s a call option, you can use, or exercise, the option to purchase a stated number of shares at the strike price. Put options allow you to sell shares at the strike price. The effect of an increase in the price of the stock on a stock option depends on the type of option and on where the stock price is in relation to the strike price.
Out of the Money Calls
Suppose you purchase a call option and the market price of the underlying stock is less than the strike price. This is referred to as being “out of the money.” If you exercise this option, you have to pay a strike price to buy the shares that is more than the market price, so you can’t make a profit by selling the stock at market. This remains true as long as the stock price stays below the strike price. For example, if the strike price is $25 per share and the market price rises from $15 to $20, you still can’t sell the shares for as much as you’d have to pay to exercise the option. The only value the call option has is a premium the option contract seller, called the writer, charges to cover her costs.
Call options start to have value when the underlying stock’s price rises above the stock price. The call option is now “in the money” and the more the stock price goes up, the more the price of the option rises. If the strike price is $25 and the stock goes up to $30, you can make $5 per share by exercising the option – so $5 plus the premium is the price of the option. If the stock keeps going up to $35, that’s $10 per share more than the strike price. The call option is now worth $10 per share, plus the premium.
Put options work in reverse to call options. A put option is in the money when the market price is less than the strike price. This is because you can buy the shares on the market and sell them to the option writer, who has to pay you the higher strike price. Suppose a put option has a strike price of $50 per share and the market price is $35 per share. You can buy the stock for $35 and sell it using the put option for $50 per share. You make $15 per share, so the option price is $15. But if the stock price goes up to $45 per share, exercising the option only nets you $5 per share. In other words, when the stock price goes up, the price of a put option goes down.
Puts Out of the Money
When a stock’s market price rises above the strike price, a put option is out of the money. This means that, other than the premium, the option has no value and the price is close to nothing. The reason is simple: you would have to pay more for the shares than the strike price you would get by exercising the option to sell the shares. Consequently, once the stock price rises to the strike price of a put option, the price of the option reaches zero and stays there unless the stock price drops below the strike price.