What are stock options? Have you ever asked yourself this question after hearing someone mention the topic casually? This type of trading has become increasingly popular over the years and for good reason. However, if you’re still unsure what they are, keep reading as we cover the subject thoroughly.
The Basic Definition
Put simply, options are the choice to buy or sell a stock at a price previously agreed upon either by a certain date or within a specific time period. One party sells the option to do so to another, hence the name. In options trading, we call buying a “call” and selling a “put.” The cost of an option is usually referred to as a “premium.”
That’s the basic definition. However, if you’ve ever wondered, “what are stock options?” then you probably want to know a bit more about this popular trading method.
An Example of an Option Trade
Let’s look at a hypothetical, wherein Acme Nails’ stock price is at $60 on May 1st. Its premium is selling for $3 for a July 70 Call. This would mean that the expiration is going to be on the third Friday in the month of July. Its strike price at that time will be $70.
Your total cost for a contract is the premium multiplied by 100 (which is usually how many shares you’re betting on with a stock option). In this example, then, you’d be spending $300.
Keep in mind that, in real life, there would be commissions paid to the broker that you’d have to consider. For the sake of simplicity, though, we’re going to leave those out of this example.
That strike price we mentioned earlier, $70, is what the stock price will have to surpass before our call option becomes profitable. As the contract in this scenario is for $3, the break-even price would be $73.
At the moment, the stock is no good to us if it stays at $60 as this would be below the strike price. On top of that, you also have to remember that you’ve paid $300 for this contract, so you’re currently out this amount.
Now, let’s say that three weeks pass and the stock price for Acme Nails is now at $75. Let’s also imagine that the options contract amount has increased along with the stock too (which is realistic, considering how in demand it would be given the movement it’s shown). Say it moved up to $8.00. You would have made ($8.00 – $3.00) x 100, which would be $500. You nearly doubled your money in just a few weeks.
At this point, you could “close your position”, meaning sell the option and take that money. You could also decide to hang onto it if you think the price is going to keep rising.
There’s much more to stock options than this. However, hopefully this has answered the question, “what are stock options?” even if it doesn’t necessarily mean you’re ready to become a trader.