In addition to buying and holding securities, investors can also purchase stock options to either protect an investment or leverage price volatility. Puts and calls are the most basic forms of these contracts, and provide the foundation for more complex contracts.
Using only two terms might seem like an oversimplified explanation for what is deemed a sophisticated investment strategy. But the put and call option need to be fully understood before moving to more complex structures. In this article, we're going to explain exactly what each of these terms mean, provide several examples, and finish up with a quick mention of the risks and rewards involved with this approach to investing in the stock market.
Understanding Stock Options
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It's often helpful to start with the basics, which includes a clear working definition of the term at hand:
A stock option is a contract that gives the investor the right to either acquire or sell a stock at a future point in time at a pre-established price.
As is the case with nearly all market trades, a contract is the basis for the transaction. Puts give the investor the right to sell a stock, while calls provide the right to buy it.
Stock Option Quotes
Stock options quoted in the newspaper, or online, are usually stated in terms of 100 shares of stock. The elements typically found in a quote include:
Strike Price: the potential purchase price of the stock for a given contract
Symbol: the stock's ticker symbol in addition to contract information (explained below)
Last: the most recent price at which the contract traded
Change: the movement or the variation in the contract's trading price
Bid: the amount an investor is willing to pay for the contract
Ask: the payment an owner is willing to take for the contract
Volume: the number of contracts traded on that day
Open Interest: contracts that have been traded, but not yet liquidated
The symbol for an option's contract typically contains the stock ticker of the company, the contract's expiration date, a call or put designation, and the strike price. For example, a 3M put contract with a strike price of $92.50 expiring on December 15, 2020 would be written as (ticker, date (YYMMDD), option, price):
MMM201215P000925000
Put Options
When an investor purchases a put option, they are purchasing the right to sell 100 shares of the stock, at a specific price, on or before the option's expiration date. The price at which the investor can sell the stock is known as the exercise price or strike price. Selling the stock at the strike price is sometimes referred to as exercising a stock option.
Generally, an investor would purchase a put option if they believed the market price per share of the company's stock is going to fall.
Put Option Example
In this example, John buys 1 put option of Company XYZ June $80. This gives John the right to sell 100 shares of Company XYZ for $80 anytime before the option expires in June.
If the price of Company XYZ were to fall to $50 per share, then John can exercise his right, or option, to sell the stock at $80, even though the shares can be purchased at the $50 market price. This means John can realize a profit of $30 per share, or $3,000, for the 100 shares sold.
Call Options
A call option is the opposite of a put option. A call option gives the investor the right to purchase 100 shares of a stock on or before the option's expiration date. Once again, the price at which the shares can be sold is called the exercise price or strike price.
Generally, an investor would purchase a call option if they believed the price per share of a company is going to rise.
Call Option Example
In this example, Lindsey buys 1 put option of Company XYZ June $80. This gives Lindsey the right to buy 100 shares of Company XYZ anytime before the option expires in June.
If the market price of Company XYZ's stock were to rise to $100 per share, then Lindsey can exercise her right to buy 100 shares of stock at $80, even though the shares now cost $100. This means Lindsey can realize a profit of $20 per share, or $2,000, for the 100 shares purchased.
Forecasting the Market
Looking at the stock market holistically, a large number of outstanding call options are a sign of optimism. Investors are more inclined to believe that stock prices will increase. A larger number of put options is generally viewed as a more negative, or bearish, outlook on the market.
When purchasing either a call or put option, the investor is basically placing a bet the market price of the company's stock will move away from its present selling price. An option is termed "in the money" when sufficient movement has occurred to allow the investor to sell the option at a profit. Options that never reach the point of being profitable are usually allowed to expire, and the investor loses the price paid for the option. This topic is covered more thoroughly in our article: Moneyness.
Risk and Rewards
Buying stock options is considered taking a leveraged position in the market because the small price paid for the option itself gives the holder the right to 100 shares of stock. Listed below are some of the risks and rewards undertaken when buying these contracts:
The holder of a call option, sometimes referred to as the option holder, has limited financial risk. They cannot lose more than the premium paid for the contract, since they always have the choice to "abandon the option."
The potential gain on a call option is theoretically without limit, since higher market prices for the stock translate into larger rewards for the option holder.
The owner of a put contract, sometimes referred to as the option writer, has limitless financial risk since the price of a stock is without theoretical limits.
The maximum gain, or reward, to the writer of a put contract can be calculated based on the strike price times the number of shares involved. For example, an option writer of a stock with zero value still has the right to sell the stock at the strike price.
Limiting Risk
The risk of an option writer can be limited when taking what is termed a covered position. An option owner is considered covered if they actually own the underlying stock for which the option is written. This approach is often used to lock in a profit as well as limit a potential loss for stocks held in a portfolio.
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