Defining Options
Before getting into options terminology, it’s helpful to get some background on options themselves. Just like stocks and bonds, options are securities that trade on an exchange. They fall into a category called “derivatives” because they’re derived from, or linked to, another security, and their prices are dependent on the price changes of that security. You’ll also hear the security or asset the option is derived from called “the underlying asset” or “the underlying.”
Call and Put Options
You can buy or sell two different types of options: a put or a call. If you buy a put option, you’ve purchased the right, but not the obligation, to sell the underlying asset at an agreed-upon price. Call options work in reverse: They give you the right to purchase the underlying asset at a predetermined price, but not the obligation. Options are often used to hedge or limit your risk on investments. For example, suppose you want to purchase a certain stock, but only if you think the price will jump up. You would buy a call option to lock in the stock price to make sure you can buy it for your portfolio before the price jumps. You would buy a put option if you owned the stock but wanted to make sure you could sell it if the price drops below a certain level, so you don’t lose money. Options are often referred to as insurance policies because they give you a certain level of protection against price fluctuations when used strategically in your investing portfolio.
Option Strike Price
The option seller sets the strike price for each option they sell; the seller is also called the “option writer.” When you buy a call option, the strike price is the price at which you can buy the underlying stock if you want to use the option. For example, if you buy a call option with a strike price of $10, you have a right, but no obligation, to buy that stock at $10—even if its price increases to more than $10. You could also sell the call option for a profit. Your profit then is approximately the difference between the underlying stock price and the strike price. When you buy a put option, the strike price is the price at which you can sell the underlying asset. For example, if you buy a put option that has a strike price of $10, you have the right to sell that stock at $10, even if its price is below $10. You may also sell the put option for a profit. The profit is approximately the difference between the strike price and the underlying stock price. Just like the call option, you may also exercise your option and sell or short the stock at $10, even if it is trading at $5 on the stock exchange.
The Exercise Price
An option buyer pays a price called a “premium,” which is the cost of the option, for their right to buy or sell the underlying asset at the option’s strike price. If a buyer chooses to use that right, then they are “exercising” the option. In other words, the option’s strike price is synonymous with its exercise price. Traders don’t have to exercise an option because it is not an obligation. You only exercise an option if you want to buy or sell the actual underlying asset. It’s important to note that most options are not exercised, even the profitable ones. For example, say you bought a call option for a premium of $1 on a stock with a strike price of $10. Near the expiration date of the option, the underlying stock is trading at $16. Instead of exercising the option and taking control of the stock at $10, the options trader will typically sell the option, closing out the trade. In doing so, they net approximately $5 per controlled share. Since one option controls 100 shares of stock, this trade nets $500. The math is as follows: A $16 share price less the strike price of $10 means the option is worth approximately $6. The trader paid $1 for the option, so the profit is $5. The option is worth approximately $6 because other factors affect the value of an option aside from the underlying stock price. These other factors are called “Greeks,” for the Greek letters that represent them. The strike price (or exercise price) is the price at which you take control of the underlying stock should you choose to exercise the option. Regardless of what price the underlying security is trading at, the strike price (or exercise price):
Is known when you buy the option contract Doesn’t change for that specific option Is fixed
The Option’s Expiration Date
Options contracts specify the expiration date as part of the contract specifications. For European-style options, the expiration date is the only date that an in-the-money (in profit) options contract can be exercised. That is because European-style options and positions can’t be exercised or closed before the expiration date. For U.S.-style options, the expiration date is the last date that an in-the-money options contract can be exercised. Options contracts that are out of the money (not in profit) on the expiration date are not exercised and expire worthless. For example, if you buy a call option with a strike price of $10, and the underlying stock currently trades at $9 on the stock exchange, there is no reason to exercise that option; it is worthless on the expiration date. Any premium paid for that option is forfeited. Options traders who have bought options contracts want their options to be in the money. Traders who have sold (or written) options contracts want the buyer’s options to be out of the money and expire worthless on the expiration date. When a buyer’s option expires worthless, that means the seller gets to keep the premium as a profit for writing or selling the option.
Which Options Make the Best Buys?
There isn’t any specific methodology that can point to the best options to buy or sell for each investor. Everyone has their own objectives for maximizing profit, hedging risk, and choosing which securities make sense for investing purposes. However, if you’re searching for ideas on where to start looking, consider trading options on the most popular stocks. They will have a lot of volume (trading activity) and a lot of options-trading activity. For example, Bank of America Corp (BAC), Meta (FB), formerly Facebook, and Micron Technology (MU) are three active stocks with more than 100,000 options being traded on them every day.
Naked Options
You could also buy options that are popular, with a lot of liquidity or trading activity, but only for stocks priced under $20. This works well if you choose to sell naked options, because it won’t require you to have a large amount of margin available to buy the stock if the options are exercised. To sell an option naked means writing or selling the option without having a position in the underlying security. You would buy the option at a more favorable price, close out the trade, and make money on the price differential to take profit. This riskier strategy has, theoretically, unlimited downside and is best used by seasoned traders.
