6 Aug 2018

What is a ‘Stock Option’

Stock options are sold by one party to another, that give the option buyer the right, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain period of time.  American options, which make up most of the public exchange-traded stock options, can be exercised any time between the date of purchase and the expiration date of the option.  European options, also known as “share options” in the United Kingdom, are less common and can only be redeemed at the expiration date.

Breaking Down the ‘Stock Option’

Stock options normally represent 100 shares of an underlying stock. Therefore, if the premium (cost) of an option is $0.10, buying one contract costs $10 ($0.10 x 100 shares), plus any fees or commissions.

Put and Call Options

A call is when the buyer has the right to purchase stock at a specified price before the option expires. A put option is when the buyer has the right to sell stock at a specified price before expiration.

The purchaser of a call option believes that the underlying stock will increase in price, while the seller of the option thinks otherwise. The option holder has the benefit of purchasing the stock at a discount from its current market value if the stock price increases prior to expiration. For example, if the strike price of an option is $10, the trader buys the option for $0.50, and the underlying stock increases to $12 at expiration, the traders nets $1.50 per share, while only having put up $0.50 of capital per share. The amount paid for the option is the most the option buyer can lose.

If the option buyer believes a stock will decline in value, they buy a put option as this gives them the right to sell the stock at the strike price before expiration. If the underlying stock loses value prior to expiration, the option holder makes money. For example, if the strike price of a put option is $50, the trader paid $1 for the option, and the stock falls to $45 by expiration, the trader nets $4 per share. On one contract that is $400, and the trade only cost $100 to make. In this case, if the stock goes up instead, the cost of the option is the most the option buyer can lose.

The strike price, relative to the current price of the underlying stock, is what dictates whether or not an option is valuable. The strike price is the predetermined price at which the underlying stock can be bought or sold.  Time value and volatility also play a significant role in the price of an option. High volatility increases the cost of an option, as does the amount of time until expiry. Since more volatility and more time mean an increased chance the price could move through the strike price, this will make the options more expensive than options with lower volatility and less time till expiration.

Writing Options

While some trader buy options, other need to write them. The writer is on the opposite side of the trade as the buyer. The writer receives the premium for writing the option. This is their maximum profit.

In exchange for receiving the premium, the writer takes on the risk of having to buy or sell shares from/to the option buyer at the strike price. This could mean large losses. For example, if a trader writes a call option the option buyer has the right to buy at the strike price. Say the strike price is $10, but the stock price shoots up to $30. The option writer is still responsible for providing the shares to the option buyer at $10. This means, if the option is exercised, the writer will need to buy shares at $30 only to sell them to the call buyer at $10, a loss os $20 per share.

Writers can protect themselves by writing covered calls. This is a common strategy. An investor already owns shares of a company. Instead of selling the stock directly, they write call options for a strike prices above the current stock price. For this they receive the premium. If the stock does rise above the strike price they simply sell the call buyer their own shares.

Option writers can also use puts to accumulate a stock position they want. For example, if a stock is trading at $15, but a trader wants to buy it at $13, instead of waiting for the price to drop they can write put options right now with a strike price of $13. For this they receive income/premium. If the stock drops below $13, they buy the shares they wanted anyway. If the strike price stays above $13 they keep the premium and can continue to write puts until they get the stock position they want.

Employee Stock Options

Employee stock options are similar to call or put options, with a few key differences. Employee stock options normally vest rather than having a specified time to maturity. This means that an employee must remain employed for a defined period of time before they earn the right to purchase or receive their options. There is also a grant price that takes the place of a strike price, which represents the current market value at the time the employee receives the options.

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