What is a Stock Option?

February 12, 20236 min read
What is a Stock Option?
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Key Takeaways

  • Stock options give investors the right to buy or sell shares of a specific stock for a mutually established price and time period.
  • Calls and puts are the two main types of options contracts.
  • Investors are not obliged to exercise their stock options.

While they have been around for some 40 years, stock options are just beginning to gain traction with mainstream investors. Despite a reputation for being relatively risky investments only seasoned traders can grasp, they have shown benefits for individual investors. The following explores stock options and how this type of equity derivative can affect investment portfolios.

What is a Stock Option?

A pact in which the buyer in a stock option gains the right to purchase or sell underlying stocks at a set price and within a specific time frame is referred to as a stock option. The buyer is not required to exercise their rights, however.

Also called equity options, stock options are derivatives, meaning their worth is tied to the value of an underlying asset or security. With stock options, the asset is shares of a company’s stock.

In turn, the stock option seller, called the option writer, gets a premium for the contract that was sold to the buyer. The premium is determined by taking the call’s price and multiplying it by the number of contracts bought, then multiplying that by 100. Generally, a single equities contract represents 100 shares of the underlying asset.

Several exchanges list stop options for trading, including the Philadelphia Stock Exchange (PHLX), the Chicago Board Options Exchange (CBOE), and the International Securities Exchange (ISE), and others.

When having stock options explained, it is also important to know that investment banks also buy call or put options, separately or together. They generally do so when applying trading methods such as covered calls.

What are the Types of Stock Options?

The two main types of options contracts are called calls and puts. With the former, the investor speculates that the price of the underlying stock will ultimately rise. With a put option, the investor speculates the underlying stock’s price will, at length, fall.

Calls

For example, a trader speculates that ABC Corp. stock will increase to more than $170. They wind up buying 10 $170 “calls” that trade at $16.10 per contract. Buying the calls requires a trader outlay of $16,100.

For the trader to turn a profit, though, the stock must surpass $186.10 — the strike price plus the cost of the calls. If the stock does not increase above $170, the option expires without value and the trader loses the whole premium.

Puts

On the other hand, if the trader speculates that ABC Corp.’s stock will drop, they could purchase 10 $120 “puts” for $11.70 per contract. That would set the trader back $11,700. To earn a profit, the stock would have to drop under $108.30. If the stock closes over $120, the options will expire and lose value, resulting in loss of the premium.

What are the Different Aspects of Stock Options?

Stock options have a lot of moving parts, but their chief components include:

An Expiration Date

Contracts only exist for a certain period, which means they have expiration dates. Note that there is a greater chance of an option gaining intrinsic value the longer the underlying asset has to move around. Thus, options that are listed with protracted expiration dates generally have more time value.

Option expiration dates are established according to a set schedule called an options cycle. Such dates can be daily, weekly, monthly, or even annually.

American vs. European Options

The two options styles are American and European. American options, which are more common, can be exercised at any point between the purchase and expiration date. By contrast, European options may only be exercised on the exact date the contracts expire.

A Strike Price

The strike price is the price a trader expects a certain stock to be over or under when the expiration date arrives. Thus, the strike price establishes whether an option should be exercised.

Real-World Example of a Profitable Stock Option

Say an investor speculates that, in three months, stock Y’s price will increase from its current value of $10. The investor subsequently buys a call option with a $50 strike price – the amount the stock must surpass for them to profit. At length, the expiration date arrives, and stock Y’s value is now $70. Because the stock’s price is $20 more than the $50 strike price, the call option is worth $20.

By contrast, if the underlying stock falls below the investor’s strike price by the expiration date, the investor will profit from a put option.

What are the Benefits and Limitations of Stock Option Trading?

Stock option trading has its advantages and drawbacks, including:

Benefits

  • Possible heightened cost efficiencies. An investor can take an option position that is similar to a stock position, but at significant cost savings.
  • If properly used, they may potentially be less risky overall than equities. While buying options can be riskier than having equities, there are also situations in which options can be employed to lower risk. For one thing, stock options call for less financial commitment than do equities.
  • They can potentially deliver higher-percentage returns. Spending less money and making nearly the same profit generally means a bigger percentage return.
  • They provide a number of strategic options. Options are relatively flexible and can be used to recreate other positions.

Limitations

  • Lower liquidity. The fact is that many stock options just do not have much volume.
  • Less data. Quotes or other standard analytical information such as implied volatility may be relatively scarce.
  • Time decay. As options are bought, their time value is lost and cannot be retrieved.
  • Options are unavailable for some stocks. While options are generally available on a sizable number of stocks, there still are limitations in this area. That means fewer opportunities.
  • Higher spreads. Due to their lack of liquidity, options usually have higher spreads. What that means is that more will be paid in indirect costs when trading an option. Why? Because the trade requires relinquishing the spread.
  • Complicated. Even some seasoned investors overestimate their understanding of stock options, which can be quite complicated to beginners.
  • Higher commissions. Traders will pay more in commissions for every dollar invested. Such commissions might be even higher for spreads for which commissions must be paid for both sides of the trade.
  • Wait period. Investors may be required to wait up to three years before reaping a stock option’s benefit.
  • Possible tax risk. When it is time to sell, careful planning may be required to ensure inclusion in the lowest-possible tax bracket.

Rise above Volatility

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Other Ways to Diversify Investment Portfolios

While stock options can be an efficient investment strategy, there are other ways to diversify one’s portfolio, namely through alternatives. Assets such as art and real estate are not directly tied to volatile markets and can deliver consistent secondary income.

Yieldstreet is helping to drive alternatives’ increasing popularity. The online investment platform, which focuses on generating passive income streams, offers vetted opportunities with various yields, durations, and minimums. To date, more than $3 billion has been invested with Yieldstreet.

The bottom line is that, rather than invest exclusively in traditional markets, a better move might be to add to assets with low correlation to ever-changing public markets to portfolios.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

A stock option basically permits investors to gamble on the rise or fall of given stocks by a time certain. The other side of that, though, is that such speculation is risky, as is the stock market in general.

All investments carry risk. However, because alternatives are not directly linked to market volatility, such assets can help mitigate overall portfolio risk.

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