Buying a stock option is more complicated than buying a stock, and has a different risk profile. A stock option is the right, but not the obligation, to transact (buy or sell) at certain price (strike price) for a period of time (contract length). Here is a basic summary of why and how to buy stock options, along with a few helpful stock options tools and tips.
A call option is a contract that gives the purchaser the right, but not the obligation, to buy a stock at a determined price (strike price) for a length of time (contract length). Options trade in 100 share lots, so one contract is the right to buy 100 shares at the strike price. To gain this right, the purchaser pays a premium (determined by the contract price multiplied by the number of underlying shares, multiplied by the total number of contracts).
The price of a contract is determined by a number of variables beyond the scope of this introduction. In the order of “least risky and most expensive” to “riskiest and least expensive”, a call option that is In The Money is one where the stock price is trading above the strike price. An At The Money call option is where the stock price is equivalent to the strike price and an Out Of The Money call option is one where the stock price is trading below the strike price.
A put option is a contract that gives the purchaser the right, but not the obligation, to sell a stock at a determined price (strike price) for a length of time (contract length) for a premium (contract price * number of underlying shares * number of contracts). The price of a contract is determined by a number of variables beyond the scope of this introduction. In the order of “least risky and most expensive” to “riskiest and least expensive”, a put option that is In The Money is one where the stock price is trading below the strike price. An At The Money put option is where the stock price is equivalent to the strike price, and an Out Of The Money put option is one where the stock price is trading above the strike price.
For both call and put option the maximum loss is equivalent to the premium paid by the investor. The premium is calculated as:
contract price * number of underlying shares * number of contracts
A stock can theoretically go to infinity. The maximum reward is:
Infinity – (Strike Price + Premium)
The most a stock can fall is to zero. The maximum reward is:
Strike Price – Premium
There are several reasons investors will choose to buy stock options. Hedging a long position can be done with an Out Of The Money put option. Entering a position can be done with an At The Money call option. Speculating on a stock price increase can be done with Out Of The Money call options.