Tradable stock options, also called derivatives, don’t have any value of their own. Their value, if any, derives from the underlying stock. Although derivatives are a high-risk form of investing, you can trade stock options for profit. Stock options can also be used to minimize investment risk, depending on your investment strategy.
Tradable stock options are contracts that allow the owner to buy or sell shares of stock for a designated strike price: the price the owner pays or receives for the shares. You may exercise the contract at any time until the date it expires, but you aren’t obligated to do so. Stock options are traded on markets such as the Chicago Board Options Exchange, the New York Stock Exchange and the International Securities Exchange. You can purchase stock options by paying a premium, the fee the option writer charges for the contract. An option writer, the party who sells the contract, collects the premium and is responsible for fulfilling the terms of the contract if it is exercised. In options trading, you may take on the role of options writer and sell options contracts if you wish.
Stock option writers sell options contracts and collect premiums. If the options are never in the money, the contract purchaser can let it expire and the writer keeps the premium. If the stock price changes so the option is "in the money," or making profit, the writer must sell or buy the shares, depending on whether the options are puts or calls. Option writers employ strategies to limit risk. For example, an option writer might sell a “covered call.” This means the option writer buys the shares called for in a contract when she writes the option. If the stock goes up, she delivers the shares she bought and keeps the premium. Experienced options traders usually use a combination of writing and purchasing puts and calls to limit risk and maximize profit.
Call options are contracts that let you buy shares at the strike price. Suppose you buy a call option contract for 100 shares of XY Company with a strike price of $20 per share and pay a premium of $1 per share. Your break-even point for this example is $21 per share -- the strike price plus the premium. If the share price rises to more than $21, the call option is “in the money.” Suppose the price goes up to $23. You exercise the option to buy the shares for $20 and then sell them for $23. Your profit is equal to $3 per share minus the dollar a share premium, or $2 per share. The catch is that if the price doesn’t go up before the options expire, you can’t make a profit. All you can do is let the contract expire and you lose the premium you paid.
Put options let you sell shares instead of buy them. You make a profit if the underlying stock goes down in price. Suppose you purchased put options for XY Company with a strike price of $20 and the share price falls to $15. You buy the shares on the market for $15 and then exercise your put option. The option writer must buy the stock for $20 per share. You make $5 per share minus the premium you paid.
If you have invested in actual shares of a company’s stock, you can use put options to limit potential losses. Let’s say you own 100 shares of AB Corporation and the share price is $40. You want to hold the shares because you think the price will go up, but you don’t want to risk losing money if the price goes down. You pay a premium for put options for 100 shares and a strike price of $40. If the stock goes up, you make a profit. If the stock goes down, the put option will gain value at the same rate the shares lose value, so your downside risk is reduced to the cost of the premium.