If you have spent any significant amount of time working in the financial industry, you have undoubtedly become familiar with the term “options.” Stock options are versatile financial instruments that can either be used to generate substantial profits or to mitigate the risk of existing holdings.
They are regarded as a very significant tool with a wide range of applications, and it is recommended that every investor learn how to make use of them. In this article, we will discuss the two different kinds of options and explain them in a way that is easy to understand for a beginner. Keep reading to find out more about the ins and outs of your options.
What Are Stock Options?
First things first, understanding options can be challenging for new traders, so it’s a good idea to grab a notebook and take some notes. Trading stocks and options share a great deal of similarities, with only a few key distinctions between the two. So, let’s get a basic understanding of buying and selling stocks first.
Let’s say you are feeling keen on investing in a particular stock, in this example Microsoft. If Microsoft is trading at $245 and you think it’s going to go up, you can invest in it and hopefully make a profit. If the price goes up at lets say $300, then you have made a profit of $55.
Although if the price goes down to, let’s say, $150, then you have lost $95. Essentially, when you buy a stock, the profit and loss are directly linked to the movement of the stock price. Simply put, if Microsoft goes up $1, you make exactly $1.
Stock Options
An investor with a stock option may purchase or sell a stock at a set price and a specific date. Options are bets on whether a stock will decrease (puts) or increase (calls).
Call Option
Let’s take a look at what happens when you buy a call stock option. When you purchase a stock option, you are essentially purchasing the right to transact on a stock at a specific time before a predetermined expiry date.
So, instead of purchasing Microsoft stock at $245, you decide to purchase the option to purchase Microsoft stock at $245. A call option is a form of option in which you acquire the right to buy a stock at a certain price.
Assume you paid $15 for this call option, which provides you the right to buy Microsoft shares at $245 at any point before the expiration date. When the stock, for example, achieves a price top of $300, you may buy it for $245, which is also called the strike price. Without taking into consideration the call option price, this results in a profit of $55.
But what if you bought a Microsoft option at $245 and it fell in value? In this example, if the option costs $15, you would simply lose the money placed in the option. This is due to the fact that you would not want to purchase the stock at a price lower than the strike price.
In this situation, options provide you with a lot of upsides; a modest loss and a tremendous potential payoff. Although it does have certain limitations, such as an expiration date that prevents you from trading the stock after it has expired. Furthermore, certain solutions may be extremely expensive to purchase in the first place. This implies that when you buy an option, you must correctly predict the market direction and time frame, which is difficult to do.
Put Option
When an investor buys put options, they are granted the right to sell the underlying stock at the strike price at any time before the option’s expiration date.
Therefore, in this scenario, the investor has the ability to exercise their right to sell the Microsoft shares ($245) at any moment up to the expiration date or on that day itself. In the event that you choose to sell the stock, the option issuer is obligated to purchase that stock from the investor at a price of $245 per share.
This is due to the fact that someone had to take the other side of the transaction, and under this agreement, the issuer agreed to take that side. Therefore, in the event that Microsoft’s share price falls below the strike price of $245. In this particular scenario, it falls to $200, and the investor has the option of selling Microsoft for $245; thus, he has earned a large profit of $45 per share of Microsoft stock.
When an investor purchases a put option, the investor increases their profit potential in proportion to the decline in price that occurs in the underlying stock. Because the price of a share of stock cannot go below zero dollars, the maximum amount of profit that an investor may earn is limited by this circumstance.
If this scenario plays out, the person selling the option will not earn a profit and will instead suffer a financial loss. Because the put seller is obligated to purchase the shares at the strike price, which is much higher than the current price of the stock.
Let’s take a look at what would take place if the price of Microsoft increased to, say, $300. In this particular scenario, the investor has the right to sell the asset at the striking price of $245; but, if the asset were to be sold on the market for $300, the investor would not exercise their right to sell at the strike price.
This option will run out of time and become worthless; thus the investor will simply lose all of the money that they paid to own that option before it expired. However, in the case of the seller of the put option, they will not be required to make a purchase at the strike price and instead will make a profit equal to the amount that the investor paid for the put option.
A Brief Review Of Options
Let’s go through the fundamentals of options one more time now that you understand the basics. When an investor purchases stock options, they gain the right to buy and sell a specific stock during a specified period of time before the option’s expiration date. When an investor purchases a call option, they gain the right to buy the underlying asset, while purchasing a put option grants them the right to sell the asset.
The current market price of the underlying stock needs to be lower than the strike price of any call options purchased on that stock in order to generate a profit. The strike price of a put option must be greater than the stock’s current price on the market for the option to generate a profit.
Takeaways
- Options are versatile financial instruments that can either be used to generate substantial profits or to mitigate the risk of existing holdings.
- Trading stocks and options share a great deal of similarities, with only a few key distinctions between the two.
- When you purchase a stock option, you are essentially purchasing the right to transact on a stock at a specific time before a predetermined expiry date.
- When an investor purchases a call option, they gain the right to buy the underlying asset, while purchasing a put option grants them the right to sell the asset.
- The current market price of the underlying stock needs to be lower than the strike price of any call options purchased in order to generate a profit.
- The strike price of a put option must be greater than the stock’s current price on the market for the option to generate a profit.
