Stock Options Explained in Plain English

Options are often even more volatile than the stock market.

Options are often even more volatile than the stock market.

Options give you the right to buy or sell a certain stock at a certain price by a certain date. Stock options trade on their own market and consist of three major components: the name of the underlying stock, a stock price and the option expiration date. Investors can use options conservatively to hedge against losses, or aggressively, to speculate on future stock price movements. Some employers provide stock options as part of a compensation package.

Call Options

A call option gives you the right, but not the obligation, to buy or "call" stock away from another investor. The option you buy tells you which stock you can buy and what you have to pay for it, along with when that right expires. Each option entitles you to buy 100 shares, and every stock option expires on the third Saturday of the indicated month. For example, if you buy an IBM January 50 call, you have the right to buy 100 shares of IBM stock at $50 per share before the option expires on the third Friday in January. The actual act of buying the stock is known as exercising the option.

Put Options

A put option is essentially the opposite of a call option. A put option gives you the right to sell or "put" a stock to an investor at a certain price. For example, if you buy an IBM August 70 put, you have the right to sell 100 shares of IBM stock at $70 per share, as long as you exercise the option before the third Saturday of August. Since you are selling stock when you exercise a put option, you need to own the stock at the time of exercise. If you don't have the stock, you must buy it in the open market.

Naked vs. Covered

When you buy or sell an option, your transaction is considered either "covered" or "uncovered." A covered option means that you own the stock underlying the option, while an uncovered or "naked" option means that you don't. For example, if you sell a covered IBM March 90 call, it means you have at least 100 shares of IBM. If the call is exercised, you simply hand over the stock at $90 per share. This is a conservative option strategy. Selling an uncovered call, on the other hand, subjects you to a potentially huge loss if the market rallies against you. For example, if you sell an uncovered IBM January 80 call and the stock goes to $500, you are obligated to sell the stock at $80 if the option is exercised. Since you don't own the stock, you will have to buy it at the current market price, or $500 per share.

Options as Compensation

If your employer provides you with stock options as part of a compensation package, those options are usually private options that cannot be traded on an exchange. These types of options function as call options that can only be used to purchase employer stock by a certain date. The taxation of your options may vary depending on the type your employer grants you.

Risks

Options are leveraged investments, meaning they can move dramatically up or down in value. Unlike stocks, options have a time component that decreases in value daily until the expiration date is reached, at which point many options expire worthless. While buying an option limits your risk to the amount you pay for the option, selling an option can subject you to a greater liability. For example, if you sell an IBM July 100 put that gets exercised, you will have to come up with $10,000, or $100 per share times 100 shares. The loss on an uncovered call is theoretically unlimited, as you must buy the stock in the open market regardless of price if your call is exercised.

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