Intro to options: A different way to participate in the stock market

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Flexibility and defined risk.

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Pretty much everyone with investing experience knows how to buy shares of a stock—it’s one of the first things we learn to do as investors. Armed with a brokerage account, you can become part owner of a publicly traded company simply by purchasing shares directly through an exchange.

Suppose you’ve identified an attractive company that you believe has a bright future. You might purchase 100 shares at a price you feel is attractive, say $50 per share. So you’d put up $5,000, plus commission and any other transaction costs, to purchase 100 shares.

For every dollar the share price rises, you make $100. For every dollar it falls, you lose $100. If the share price doubles, you double your money. If the company goes bankrupt, you lose the entire $5,000.

But what if you could control those same 100 shares with only a fraction of the capital and limit your maximum risk in case something catastrophic happens? Welcome to the world of options. If it sounds too good to be true, just know that—as with anything in investing and trading—there are caveats.

So exactly how can you get exposure to the upside potential of a stock, but with less up-front capital outlay and with a limit to the downside risk? By purchasing a call option contract.

A call option gives the buyer the right—but not the obligation—to purchase shares of the underlying stock at a set price (called the strike price or exercise price) by a set date (called the expiration date). For this right you pay a premium, which is the price of the option contract and, for a long call option, is also the maximum risk in the trade.

But what if you think the stock is set for a sell-off rather than a rally? You could buy a put option. This gives you the right, but not the obligation, to sell the underlying stock at the strike price on or before the expiration date. You pay a premium, which again represents your maximum risk.

There are four major components of call and put contracts:

Suppose you’re liking company XYZ’s prospects. Let’s say the stock has sold off over the last few months, but your analysis indicates a rally may be in store. The stock is currently trading at $145. You decide to look at call options that expire three months in the future with a strike price of $150.

For the next three months, you have the right to buy 100 shares of XYZ at $150 per share. You paid $300 for that right. If the stock rallies above $150, the option’s value will begin to offset that cost. If it rises to $153, the position breaks even; if it goes any higher, you’ll be in the profit zone. On the other hand, if the stock doesn’t rise the way you expect, or even if it falls precipitously, you’ll only lose the original $300 premium.

In contrast, if you bought 100 shares of stock at $145, it would have cost you $14,500 up front. Although you would profit, dollar-for-dollar, if the stock rises, you would also lose, dollar-for-dollar, if your analysis is wrong and the stock keeps falling.

Note that you don’t have to hold the call option all the way to expiration. You can choose to sell the contract anytime you want. For most stocks—and all actively traded stocks—there’s a robust market full of professional traders and market makers posting competitive bids and offers throughout each trading day.

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RISK GRAPH OF A LONG CALL VS. LONG STOCK. When you buy a stock, your profit and loss rises and falls one-to-one with the price of the stock. With the call option, once the stock price rises above the strike price, your profit potential begins to rise one-to-one with the stock price, but it must be above $153 for you to break even (to account for the premium you paid). If the stock falls, your loss is limited to the premium you paid for the call option. For educational purposes only.

Encyclopædia Britannica, Inc.

Pros cite three main reasons for choosing to trade options:

These two basic option strategies—buying call options to speculate on a stock going up, and buying put options to speculate on a stock going down—really just scratch the surface of all that’s possible with options. And they’re not just for stocks—there are options listed on exchange-traded funds, indexes, futures contracts, and more. There are even option-selling strategies that aim to generate income.

The more you learn about the options market, the more you’ll understand the allure. But they’re not for everyone. Nor are options a set-it-and-forget-it investment. The first step is education.