Category: 02. Instruments

What Is Stock Options Trading?

Trading options is very different from trading stocks because options have distinct characteristics from stocks. Investors need to take the time to understand the terminology and concepts involved with options before trading them.

Options are financial derivatives, meaning that they derive their value from the underlying security or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock at a pre-determined price.¹

KEY TAKEAWAYS

• Options give a buyer the right, but not the obligation, to buy (call) or sell (put) the underlying stock at a pre-set price called the strike price.
• Options have a cost associated with them, called a premium, and an expiration date.
• A call option is profitable when the strike price is below the stock’s market price since the trader can buy the stock at a lower price.
• A put option is profitable when the strike is higher than the stock’s market price since the trader can sell the stock at a higher price.

Understanding Stock Options Trading

Trading stocks can be compared to gambling in a casino: You’re betting against the house, so if all the customers have an incredible string of luck, they could all win.

Trading options is more like betting on horses at the racetrack: Each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So trading options, like betting at the horse track, is a zero-sum game. The option buyer’s gain is the option seller’s loss and vice versa.

One important difference between stocks and options is that stocks give you a small piece of ownership in a company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date.

It’s important to remember that there are always two sides to every option transaction: a buyer and a seller. In other words, for every option purchased, there’s always someone else selling it.

Types of Options

The two types of options are calls and puts. When you buy a call option, you have the right, but not the obligation, to purchase a stock at a set price, called the strike price, any time before the option expires. When you buy a put option, you have the right, but not the obligation, to sell a stock at the strike price any time before the expiration date.¹

When individuals sell options, they effectively create a security that didn’t exist before. This is known as writing an option, and it explains one of the main sources of options since neither the associated company nor the options exchange issues the options.¹

When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.¹

There are also two basic styles of options: American and European. An American-style option can be exercised at any time between the date of purchase and the expiration date. A European-style option can only be exercised on the expiration date. Most exchange-traded options are American style, and all stock options are American style. Many index options are European style.²

Option Pricing

The price of an option is called the premium. The buyer of an option can’t lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.

In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller’s loss can be open-ended, meaning the seller can lose much more than the original premium received.

Please note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $0.50 or $1, but can also be in intervals of $2.50 and $5 for higher-priced stocks. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in- or out-of-the-money options might not be available.

Option Profitability

When the strike price of a call option is above the current price of the stock, the call is not profitable or out-of-the-money. In other words, an investor is not going to buy a stock at a higher price (the strike) than the current market price of the stock. When the call option strike price is below the stock’s price, it’s considered in-the-money since the investor can buy the stock for a lower price than in the current market.

Put options are the exact opposite. They’re considered out-of-the-money when the strike price is below the stock price since an investor wouldn’t sell the stock at a lower price (the strike) than in the market. Put options are in-the-money when the strike price is above the stock price since investors can sell the stock at the higher (strike) price than the market price of the stock.

Expiration Dates

All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called long-term equity anticipation securities (LEAPS), are also available on many stocks. These can have expiration dates up to three years from the listing date.³

Options expire at market close on Friday, unless it falls on a market holiday, in which case expiration is moved back one business day. Monthly options expire on the third Friday of the expiration month, while weekly options expire on each of the other Fridays in a month.⁴

Unlike shares of stock, which have a two-day settlement period, options settle the next day.⁵ In order to settle on the expiration date, you have to exercise or trade the option by the end of the day on Friday.

Stock Option Trading FAQs

What Is a Stock Options Contract?

A stock option contract entitles the owner of the contract to 100 shares of the underlying stock upon expiration. So, if you purchase seven call option contracts, you are acquiring the right to purchase 700 shares. And, if the owner of a call option decides to exercise their right to buy the stock at a particular price, the option writer must deliver the stock at that price.

What Do Stock Options Cost?

Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of $0.55 per contract, buying one option would cost $55 ($0.55 x 100 = $55).

How Do You Make Money Trading Options?

You can make money by being an option buyer or an option writer. If you are a call option buyer, you can make a profit if the underlying stock rises above the strike price before the expiration date. If you are a put option buyer, you can make a profit if the price falls below the strike price before the expiration date.

Is Options Trading Better Than Stocks?

Options trading can be riskier than trading stocks. However, when it is done properly, it can be more profitable for the investor than traditional stock market investing.

What Is a Stock?

A stock (also known as equity) is a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation’s assets and profits equal to how much stock they own. Units of stock are called “shares.”

Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well, and are the foundation of many individual investors’ portfolios. These transactions have to conform to government regulations which are meant to protect investors from fraudulent practices. Historically, they have outperformed most other investments over the long run.¹ These investments can be purchased from most online stock brokers. Stock investment differs greatly from real estate investment.

KEY TAKEAWAYS

• A stock is a form of security that indicates the holder has proportionate ownership in the issuing corporation.
• Corporations issue (sell) stock to raise funds to operate their businesses. There are two main types of stock: common and preferred.
• Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well, and they are the foundation of nearly every portfolio.
• Historically, they have outperformed most other investments over the long run.¹

Understanding Stocks

Corporations issue (sell) stock to raise funds to operate their businesses. The holder of stock (a shareholder) has now bought a piece of the corporation and, depending on the type of shares held, may have a claim to a part of its assets and earnings. In other words, a shareholder is now an owner of the issuing company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the company’s assets and earnings.²

Stock holders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belongs to the corporation, and not to the shareholders.³

This distinction is important because corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold – but your personal assets are not at risk. The court cannot even force you to sell your shares, although the value of your shares will have fallen drastically. Likewise, if a major shareholder goes bankrupt, she cannot sell the company’s assets to pay off her creditors.⁴

Stockholders and Equity Ownership

What shareholders actually own are shares issued by the corporation; and the corporation owns the assets held by a firm. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”

Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.

If you own a majority of shares, your voting power increases so that you can indirectly control the direction of a company by appointing its board of directors.⁵ This becomes most apparent when one company buys another: the acquiring company doesn’t go around buying up the building, the chairs, the employees; it buys up all the shares. The board of directors is responsible for increasing the value of the corporation, and often does so by hiring professional managers, or officers, such as the Chief Executive Officer, or CEO.

For most ordinary shareholders, not being able to manage the company isn’t such a big deal. The importance of being a shareholder is that you are entitled to a portion of the company’s profits, which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the portion of the profits you get. Many stocks, however, do not pay out dividends, and instead reinvest profits back into growing the company. These retained earnings, however, are still reflected in the value of a stock.

Common vs. Preferred Stock

There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders’ meetings and to receive any dividends paid out by the corporation. Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than the common stockholders. For example, owners of preferred stock (such as Larry Page) receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.²

The first common stock ever issued was by the Dutch East India Company in 1602.⁶

Companies can issue new shares whenever there is a need to raise additional cash. This process dilutes the ownership and rights of existing shareholders (provided they do not buy any of the new offerings). Corporations can also engage in stock buy-backs which would benefit existing shareholders as it would cause their shares to appreciate in value.

Stocks vs. Bonds

Stocks are issued by companies to raise capital, paid-up or share, in order to grow the business or undertake new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). When the corporation issues shares, it does so in return for money.

Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the corporation, and are entitled to interest as well as repayment of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments that bonds.²

Frequently Asked Questions

What is a stock?

A stock is a type of security that entitles the holder a fraction of ownership in a company. Through the ownership of this stock, the holder may be granted a portion of a company’s earnings, distributed as dividends. Broadly speaking, there are two main types of stocks, common and preferred. Common stockholders have the right to receive dividends and vote in shareholder meetings, while preferred shareholders have limited or no voting rights. Preferred stockholders typically receive higher dividend payouts, and in the event of a liquidation, a greater claim on assets than common stockholders.

How do you buy a stock?

Most often, stocks are bought and sold on stock exchanges, such as the Nasdaq or the New York Stock Exchange (NYSE). After a company goes public through an initial public offering (IPO), their stock becomes available for investors to buy and sell on an exchange. Typically, investors will use a brokerage account to purchase stock on the exchange, which will list the purchasing price (the bid) or the selling price (the offer). The price of the stock is influenced by supply and demand factors in the market, among other variables.

What is the difference between a stock and a bond?

When a company raises capital by issuing stock, it entitles the holder a share of ownership in the company. By contrast, when a company raises funds for the business by selling bonds, these bonds represent loans from the bondholder to the company. Bonds have terms that require the company or entity to pay back the principal along with interest rates in exchange for this loan. In addition, bondholders are granted priority over stockholders in the event of a bankruptcy, while stockholders typically fall last in line in claim to assets.