How do stock options work

By now you might be familiar with what is the concept of an option. A contract that benefits the buyer and seller in particular ways. But do you know how do stock options work with practical examples? Let’s dive into these details and learn real examples of stock options in practice:

How a Call Option works?

Let’s imagine you want to sell your car, and the most suitable buyer tells you that he wants to buy it now for a cash deal, the price sounds great to you and you trust this buyer, but… he will only have the funds available in a month or so.

The buyer doesn’t want this opportunity to go to waste, so he’s willing to offer you a thousand dollars in cash right now if you can hold the car for him for two months at the same price.

After you agree, you both sign a contract where you indicate that you’ll hold the car at the same price for the timeframe and he will be able to elect to buy the car from you or just let the contract expire. You’ll keep the $1,000 no matter what happens.

This money that he had just paid to you is what we call “premium” in the Options wold.

By now, it is easy to see that this type of deal has many advantages for both sides. The buyer walks away with a paper that binds you, reassuring that the asset will be there available for him to buy at a later date, whenever he finally has the funds available.

The seller walks away with $1,000 extra in cash and the promise of selling the asset as agreed, if the buyer wants to execute the contract. Better then, in the case the buyer desist from purchasing the car, you’ll keep the asset and pocket the extra money.

How options contracts are applied to the investing world?

Same as with the example above, stocks can be traded directly or under an option contract. This allows the buyer to guarantee the availability of a stock at a specific price for a later date, and the seller to profit of selling their stock at a specific price, plus earning a premium.

If you’re looking forward buying a certain stock that has recently came into your radar because the favorable price range, but you cannot commit the funds yet or don’t want to tie funds into the stock right away, you can then buy a options contract, a “Call”, that will bind the seller with the obligation to sell the stock to you at the agreed strike price, if you ever want to exercise the contract.

Of course, you’ll have to pay a Premium to be able to tie the seller into this contract. This premium will never come back to you, think of it as a price to pay for having the power of executing a contract and buying the stock at your favorable price.

Come the expiration date, as a buyer you’ll have a few options:

  1. If the stock is trading at a higher price than your contract’s strike price, you can execute the contract and buy the stocks at the agreed price. You’ll then have a positive position right away, where you could technically go back to the market right away and sell the stocks for a profit.
  2. If the stock is trading at a lower price, you might want to let the contract expire worthless and loose the premium. It would be better to do so, as you can just go and buy the stocks in the market for less than the agreed strike price

The first scenario is what is know as “options in the money”, where the strike price favours you at expiration date. The second scenario is known as “an option that is out of the money”, where there’s no sense on executing the contract, as it is cheaper to buy the shares in the market.

Is there more to stock options than just buying call options?

This is not all that there is about options, if by know you know how do stock options work, at least in their basic form, you will likely want to investigate a bit further into “put options”, which give you a powerful tool when you want to guarantee that you can sell stock at a specific price, no matter what happens with the stock price during a certain timeframe.

We invite you to watch this great video made by Profits Run where both Call and Buy Stock Options are explained.

In a nutshell

In a nutshell, stock options are a great way to accumulate wealth with minimum risk, you can learn how do stock options work in all their forms and shapes and later you will be able to decide at what price to buy or to sell and you can choose the price that you want to pay for that privilege.

Used wisely, options will help you enter into a stock position at the correct price and then protect your portfolio from sudden drops in the market.