Stock options can refer to two related yet different things. The first, known as an exchange-traded option, is an agreement that can give you the option to buy or sell stock at a specific price by a specific date. Its an investment, albeit one that typically carries more risk than traditional stock investing.
The second, known as employee stock options, is a form of equity compensation that an employer may offer employees, early investors, advisors, etc. This type of stock option isnt a tradeable asset the way exchange-traded stock options are, but it still involves an agreement to buy stock at a certain price by a certain date.
Because stock options can expire worthless, investing in them or accepting them as compensation should be cautiously approached. But experienced traders can use options in various ways, including limiting potential losses.
All kinds of investors can access stock options with some of the best online brokerages and investment platforms.
Here are the basics of trading stock options, hedging strategies, and the risks involved with options contracts.
Are you confused about stock options? Don’t worry – you’re not alone! When I first heard about options trading, my head was spinning with all those fancy terms and complicated strategies. But guess what? They’re actually not that hard to understand once you break it down.
In this article, I’ll walk you through everything you need to know about stock options in simple, easy-to-understand language. No finance degree required!
What Are Stock Options, Anyway?
Let’s start with the basics A stock option is basically a contract that gives you certain rights related to buying or selling stocks, Think of it like making a reservation – but for stocks
Stock options are agreements between two parties that give the option holder the right (but not the obligation) to buy or sell a specific stock at a predetermined price within a specific time frame
The key thing to remember is that options are contracts about stocks – not the actual stocks themselves!
The Two Main Types of Options
There are two basic flavors of options:
Call Options
A call option gives you the right to buy a stock at a specific price (called the “strike price”) before the contract expires. You’d buy a call option when you think the stock price is going UP.
For example, if Amazon stock is trading at $100, and you think it’ll go up to $150, you might buy a call option with a strike price of $120. If the stock indeed rises above $120, your option becomes valuable!
Put Options
A put option gives you the right to sell a stock at a specific price before the expiration date. You’d buy a put option when you think a stock price is going DOWN.
If Tesla is trading at $200, and you think it’ll drop to $150, you might buy a put option with a strike price of $180. If Tesla falls below $180, your put option gains value.
The Players in the Options Game
In the world of options, there are two main roles:
-
Buyers (Option Holders): They purchase the right to buy or sell the underlying stock. They have RIGHTS but no obligations.
-
Sellers (Option Writers): They collect money for selling options contracts. They have OBLIGATIONS to fulfill if the buyer exercises their option.
Important Option Terms You Should Know
Let’s go through some key terms that’ll help you understand options better:
Strike Price
The predetermined price at which the option holder can buy (for call options) or sell (for put options) the underlying stock.
Expiration Date
The date when the option contract ends. After this date, the option becomes worthless if not exercised.
Premium
The price you pay to buy an option contract. This is essentially the cost of the option.
In-the-Money (ITM)
- For call options: When the stock price is ABOVE the strike price
- For put options: When the stock price is BELOW the strike price
Out-of-the-Money (OTM)
- For call options: When the stock price is BELOW the strike price
- For put options: When the stock price is ABOVE the strike price
At-the-Money (ATM)
When the stock price is approximately equal to the strike price.
Why Would Anyone Trade Options?
Options might seem complicated, but they serve several useful purposes:
- Leverage: Options let you control a lot of stock with relatively little money
- Risk Management: You can use options to protect your investments (like insurance)
- Income Generation: Some investors sell options to generate income
- Speculation: Options let you bet on a stock’s direction without buying the actual stock
A Real-World Example of How Options Work
Let’s make this super simple with an example:
Imagine Apple stock is trading at $150 per share. You think it’s gonna go up in the next month, but you don’t have enough money to buy 100 shares ($15,000).
Instead, you buy 1 call option contract (which represents 100 shares) with a strike price of $160 that expires in one month. This might cost you $300 (the premium).
Now, let’s look at different scenarios:
Scenario 1: Apple rises to $200
Your call option gives you the right to buy 100 shares at $160 each, even though they’re worth $200 now! That’s a $40 profit per share, or $4,000 total. Subtract your initial $300 cost, and you’ve made $3,700!
Scenario 2: Apple stays at $150 or drops
Your option expires worthless because buying at $160 when the market price is lower doesn’t make sense. You lose your $300 premium. But that’s your maximum loss – much less than if you’d bought the actual stock!
Employee Stock Options: A Different Animal
It’s important to note that employee stock options (ESOs) work differently than the traded options we’ve discussed so far.
If your company offers you stock options as part of your compensation, these are typically:
- The right to purchase company stock at a fixed price (usually the market price when the options were granted)
- Subject to a vesting schedule (meaning you earn them over time)
- Not tradable on public exchanges
Employee stock options are a way companies incentivize employees to help increase the company’s value over time.
The Risks of Options Trading
While options can be powerful tools, they come with risks:
- Limited Lifespan: Options have expiration dates, unlike stocks which you can hold forever
- Complexity: Options strategies can get complicated quickly
- Leverage: The same leverage that amplifies gains can also amplify losses
For beginners, I highly recommend “paper trading” (practice trading without real money) before diving into real options trading.
Basic Option Strategies for Beginners
If you’re new to options, here are some basic strategies to consider:
1. Long Call
Buy a call option when you expect the stock to rise. Maximum loss is limited to the premium paid, while potential profit is theoretically unlimited.
2. Long Put
Buy a put option when you expect the stock to fall. Maximum loss is limited to the premium paid, while potential profit is limited to the strike price (minus the premium).
3. Covered Call
Own the stock and sell a call option against it. This generates income but limits your upside potential if the stock rises significantly.
4. Protective Put
Own the stock and buy a put option to protect against price declines. It’s like buying insurance for your stock.
Options Trading Example: The Math Behind It
Let’s break down a simple example with actual numbers:
- Stock: XYZ trading at $50 per share
- Your view: Stock will rise
- Strategy: Buy 1 call option contract (represents 100 shares)
- Strike price: $55
- Expiration: 3 months away
- Premium: $2 per share ($200 total cost)
Potential outcomes:
| XYZ Stock Price at Expiration | Call Option Value | Your Profit/Loss |
|---|---|---|
| $45 | $0 (expires worthless) | -$200 (loss) |
| $50 | $0 (expires worthless) | -$200 (loss) |
| $55 | $0 (expires worthless) | -$200 (loss) |
| $57 | $2 per share ($200) | $0 (break even) |
| $60 | $5 per share ($500) | $300 profit |
| $70 | $15 per share ($1,500) | $1,300 profit |
As you can see, the option becomes profitable only if the stock rises above $57 (strike price + premium).
Common Mistakes to Avoid When Trading Options
I’ve made plenty of mistakes with options, so learn from my errors:
- Not understanding the basics: Make sure you fully grasp how options work before trading
- Ignoring time decay: Options lose value as they approach expiration
- Overtrading: Don’t trade options just for the thrill
- Improper position sizing: Never put too much of your portfolio in options
- Not having an exit plan: Know when to take profits or cut losses
Who Should Consider Trading Options?
Options aren’t for everyone. You might consider options if:
- You have a good understanding of how the stock market works
- You’re willing to learn about options mechanics and strategies
- You have risk capital that you can afford to lose
- You’re disciplined about following trading rules
- You have specific goals for using options (hedging, income, etc.)
Getting Started with Options Trading
If you wanna start trading options, here’s a step-by-step approach:
- Learn the basics: Keep reading articles, books, or take courses
- Paper trade first: Practice with fake money to test your understanding
- Start small: When ready for real trading, begin with simple strategies and small positions
- Track your results: Keep a trading journal to learn from successes and mistakes
- Gradually increase complexity: Only try more advanced strategies as you gain experience
Final Thoughts
Stock options might seem complicated at first, but they’re really just tools that give you more flexibility in how you invest. They can help you manage risk, generate income, or speculate on market movements with limited capital.
Remember that options trading involves risk, and it’s not suitable for everyone. But with proper education and practice, options can become a valuable part of your investing toolkit.
Types of stock options: call and put options explained
Different types of options contracts are traded and categorized in varying ways. The two main types of options are:
- Call options: The holder can buy the underlying stock or other asset at the strike price before the expiration. Call options generally increase in value as the underlying assets price rises. Long calls have unlimited upside potential to buyers, so investors use them to speculate on the underlying assets price. The maximum loss potential is the initial premium.
- Put option: The holder can sell the stock at the strike price by the expiration date. Put options increase in value as the price of the underlying asset falls. A long put is a short position on the underlying assets, which investors use to bet on a stock losing value or for purposes like hedging against current holdings in their portfolios. The latter risk management strategy is referred to as protective puts.
You can buy or sell either type of option. If selling calls or puts, the risk is the opposite. You get the premium up front and can keep it no matter what (though you have to pay to close out the position early). Its up to the buyer whether or not to exercise though; youre obligated as seller to act if they exercise.
But if you sell a call option and the stock price rises above the strike price, your potential losses are unlimited, as you could have to buy 100 shares at whatever the stock price at that time is and then sell them at the agreed-upon strike price for less. However, many investors use covered calls, meaning you own at least 100 shares of the underlying asset (as opposed to naked calls, where you dont own enough underlying shares and the potential losses are truly unlimited).
With covered calls, your losses are typically only opportunity costs, as any losses on the call itself are offset by gains in your underlying stock holding. That said, covered calls can somewhat lock you into a position, as you cant sell those corresponding shares while owning the option. Thus, if you want to exit early, you have to buy back the option before selling your underlying shares, which could mean paying more for the option than you sold it for.
Similarly, when selling puts, brokers often require you to have enough cash on hand to buy 100 shares at the strike price. These are called cash-secured puts as opposed to naked puts (when you dont have the cash on hand). If the asset price does fall below the strike price, you have to purchase the underlying shares for the agreed-upon price. For example, if you sell a put at $100 and the stock price falls to $95, youd spend $10,000 to buy 100 shares at $100 per share, but the value of these holdings would only be worth $950 based on the current $95 stock prices. Granted, these are paper losses until you sell the underlying asset, and its possible that the underlying stock will regain value. Still, your potential losses are as much as the value of exercising the stock option, such as if you buy in at $100 per share for $10,000, but the stock goes to $0, meaning you could technically lose all $10,000.
All thats to say, both buying and selling calls or puts can have significant risks. You might lose the premium if buying them or face steep losses when selling them if the underlying stock price moves against your position.
There are also differences between American-style and European-style options. With American-style options, the holder (aka the buyer) can exercise the option at any time before the expiration date, while European-style options can only be exercised on the expiration date.
Pros and cons of stock options
Stock option pros
- Leverage over a larger position in an asset at a cheaper price than directly buying
- Can reduce potential losses by using options as a hedge
- Potential to generate income
- Less risky than shorting stock by limiting losses
- Versatile
Stock option cons
- Risk of significant loss for both buyers and sellers
- Options lose value over time and can expire worthless, unlike owning assets directly
- Can be more volatile than underlying stocks
- Requires thorough market knowledge and understanding of complex trading concepts
- Can have high commission and fee costs
Options Trading For Beginners – The Basics
FAQ
How to understand stock options for beginners?
- Call options afford the holder the right, but not the obligation, to buy the asset at a stated price within a specific time frame.
- Put options afford the holder the right, but not the obligation, to sell the asset at a stated price within a specific time frame.
How do you make money from stock options?
A put option buyer makes a profit if the price falls below the strike price before the expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed.
What is the 7% rule in stocks?
The “7% rule” for stocks is a risk management strategy that dictates selling a stock when it drops 7% below the purchase price to limit losses and preserve capital. This rule, popularized by investors like William O’Neil, is based on the observation that even strong stocks typically don’t fall more than 7-8% below their ideal buy point. It can be implemented by setting a stop-loss order with your broker or through manual monitoring. Another related, but distinct, “7% rule” is a retirement planning concept where you assume a 7% annual withdrawal rate from your investments to determine how much you need to save for retirement, as explained in this YouTube video.
What is the 60/40 rule for options?
Non-equity options taxation
60% of the gain or loss is taxed at the long-term capital tax rates. 40% of the gain or loss is taxed at the short-term capital tax rates.