Stock Options – How Do They Work?

Wouldn’t it be nice if you could lock in a minimum price that you’ll get when you sell your car a few years from now? The ability to lock in a minimum future sales price (or maximum future purchase price) is not readily available these days for personal use assets such as cars. However, a thriving options market exists where you can lock in future sales or purchase prices for stocks, commodities, and many other types of investments.

Stock Options have become much more popular with retail investors over the past couple of years. If you have never understood stock options, today’s article will give you the basics.

Buy a “Put” option to lock in a minimum sales price:

You can lock in a minimum sales price for a stock by purchasing a “Put” Option. Let’s look at an example. Apple Computer stock is trading around $134 per share. Just two years ago, Apple shares were only $40 (split adjusted). Suppose you are thrilled with your profit and do not want to sell the stock, but you want to protect your gain. You could buy a Put option that gives you the right to sell your Apple stock at $130 a share (the option’s strike price) any time in the next year. The cost of that option as of yesterday was around $17.

You will continue to own the stock if it is valued at $130 or higher a year from now, and you will simply lose the money you spent to buy the option. However, if the stock price dropped back to $40 a share, you could still sell it for $130. The $17 you paid for the option would have protected you from the price drop from $130 to $40.

Naturally, just like there are buyers of Put options, there are investors on the other side of the transaction who are selling Put options. The seller of a Put believes the price of Apple stock will not crash and they will simply get to keep the $17 premium.

The opposite of a Put option is a “Call” option

A Call option gives you the right to buy a stock in the future at a specified price (the strike price). So, you would buy a Call option on a stock that you expected to substantially increase in value. Suppose you thought Apple stock was going to double in value from $135 a share to $270 per share. You could buy shares right now for $135 each, or you could lock in your “right” to buy them at that price anytime in the next year. The price of this option is currently around $19.25 (enabling you to control more shares right now with less money).

A common use of Call options is to sell them on a stock you already own to generate income. This is known as a “covered call.” It is covered because you own the underlying stock. If you didn’t own the underlying stock, you would be “naked” instead of covered.

Let’s look at an example: We have a client who owned a large position in Apple. Her financial plan calls for us to reduce this position. We sold Call options on the shares instead of just selling the shares immediately. Selling the Call options generates income ($19.25 per share in the above example). If the stock appreciates, it will be sold and we will keep the sales price ($135), plus the options premium ($19.25). If the stock price stays flat or declines, we keep the option premium ($19.25) and still own the shares. We could keep doing this, generating income by selling Call options against our position until the stock gets called away (sold).

Three factors determine the price of an option contract

Stock option pricing is based primarily on three factors: maturity date, strike price, and volatility of the underlying stock. Each options contract controls 100 shares of stock, which means a $10 option really costs $1,000. The fact that each options contract controls 100 shares makes it impractical for investors to use options when working with a small number of shares. For example, you would most likely not want to buy a contract to protect your Apple stock if you only own 30 shares when one options contract will control 100 shares.

Numerous scenarios exist in which investors can use stock options and options strategies to accomplish their financial goals. Stock options can be used to reduce risk (hedging) or increase income. They can also be used to speculate in quite risky ways. So, make sure you have a clear understanding of how different types of options work before you jump into the pool. If you want to learn more about options, check out: Getting Started with Options or The Options Guide.

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