Options, Their Types, and How They Work

An option is a derivative contract that gives its owner the right to buy or sell securities at an agreed-upon price within a certain time period. If you're a new investor, that may be a confusing concept. For the more savvy investor, options trading can be very enticing, because it offers the opportunity to exert more leverage over trades and to apply industry knowledge and high-level strategies.

Here we cover it all, from the basic to the complex.

Options Terminology

To start, it is important to understand what all of the building block terms mean:

• Option: You pay for the option, or right, to make the transaction you want. You are under no obligation to do so.
• Derivative: The option derives its value from that of the underlying asset. This underlying value is one of the determinants of the option's price.
• Agreed-upon price: This is known as the "strike price." It doesn't change over time, no matter what happens to the stock price. It has that name because you will strike when the underlying value makes you money.
• Certain time period: This is the time until the agreed-upon date, known as the "expiration date." That's when your option expires. You can exercise your option at the strike price at any time until the expiration date. In Europe, you can only exercise it exactly on the expiration date.

Two Major Types of Options

There are two types of options. One gives you the right to buy the asset, and the other gives you the right to sell it.

Call Option

The right to buy is called a "call option" or a "call." A call option is "in the money" when the strike price is below the underlying stock value. If you were to buy the option and sell the stock today, you'd make money, provided the sale price was more than the premium paid for it.

You buy call options when you believe the security will rise in value before the exercise date. If that happens, you'll exercise the option. You'll buy the security at the strike price, then immediately sell it at the higher market price. If you feel bullish, you might also wait to see whether the price goes even higher. Buyers of call options are called "holders."

Your profit equals the security proceeds, subtracting both the strike price and the premium for the call option. Typically, transactional fees occur as well and also must be subtracted. The option's intrinsic value is the difference between strike price and the stock's current market price. If the price doesn't rise above the strike price, you won't exercise the option. Your only loss is the premium, even if the stock plummets to zero.

Why wouldn't you just buy the security instead? Buying a call option gives you more leverage.

The other advantage is that you can sell the option itself if the price rises. You can make money without ever having to pay for the security.

You would sell a call option if you believe the asset price will drop. If it drops below the strike price, you keep the premium. A seller of a call option is called the "writer."

Put Option

With a "put option," or simply a "put," you purchase the right to sell your stock at the strike price anytime until the expiration day. In other words, you have purchased the option to sell it. A put option is "in the money" when the strike price is above the underlying stock value. So, if you were to buy the option to sell, then buy the stock today, you'd make money, because your purchase price would have been lower than your sale price.

Six Determinants of Options Pricing

There are six components that determine the price of the option:

1. Value of the underlying asset: As it increases, the right to buy granted by a call option will become more valuable. Likewise, as the stock increases, the right to sell it at a fixed price becomes less valuable, as in the case of a put.
2. Implied volatility: If traders think the price of the underlying asset will swing wildly, then options become more valuable. The increased volatility increases risk. As a result, traders demand higher returns for the options.
3. Dividends: Call options will typically lose value leading up to the ex-dividend date, since the value of the stock is lowered by the dividend amount on the record date. The opposite effect typically occurs where puts may increase in value before the ex-dividend date. The important takeaway is that stock prices are lowered by the dividend amount, while the options themselves are not.
4. Strike price: For a call, the lower the strike price, the more likely it increases in value due to being closer at the money (at the stock price) or in the money (under the stock price), meaning you can purchase the underlying security lower than the market price. For a put, the higher the strike price, the more valuable the option, since you can sell the underlying at a price higher than the market price.
5. Time period: The longer the time period, the more valuable the option.
6. Interest rates: Call options generally rise in price as interest rates increase, and put options generally decrease in price as interest rates increase.

Why Trade Options?

Options give you many advantages, but they come with high risks. The biggest advantage is that you don't own the underlying asset. You can benefit from the value of the asset, but you don't have to transport or store it. That's no big deal for stocks, bonds, or currency, but it could be a challenge for commodities.

It also allows you to use leverage. You only have to pay for the cost of the option, not the entire asset. If you buy a call option, and the price rises, you make all that profit without much investment. Your risk is much smaller if you buy a call option. You won't lose more than the premium, even if the asset's price falls to zero.

Put options can protect your investments against a decline in market prices by properly hedging your existing positions. Long-term equity anticipation securities (LEAP options) allow you to protect against drops in stock prices for up to three years. Call options can also allow you to speculate on upside moves by allowing you the right to buy a stock at a lower price.

You can also earn an income on assets you own. If you sell a call option against stock you already own, you earn income from the premiums. The biggest risk is that if the stock price rises, you lose the potential for upside profit. This is called a "covered call strategy."

Risks

One big risk is that you are competing against hedge funds and other very sophisticated traders. They spend all day, every day, analyzing option strategies. They've hired highly educated quantitative individuals who use calculus to determine the accurate price of an option. They also have sophisticated computer models that map out all potential scenarios. These are your competitors. They are on the other side of every option trade you make.

Options trading can be risky no matter how simple the strategy. Many discount brokers require extensive knowledge and assets to begin trading these sophisticated instruments. There are logistical risks not discussed in this article that can cause investors to lose a substantial amount of money if options strategies are executed improperly. As always, one should consult with their financial advisor about their risk tolerance and investment objective before considering options trading. Although some hedging protection is offered, most options trading is speculative and can result in total loss of principal.

What Can You Trade Options On?

You can trade options on stocks, bonds, currencies, and commodities. Businesses use options to protect against volatility. Investors use options to protect against future loss. Traders and speculators try to make huge profits with little investment.

Stocks

Options on stocks are the most well-known. You can buy options on an exchange-traded fund or an index. This helps you benefit from changes in the market overall, without having to research a specific company.

Currency

Currency options allow businesses to hedge against changes in exchange rates. For example, a European company could buy a currency option if it had a large payment due in U.S. dollars. If the dollar's value rose, it could exercise the option and only pay the strike price. If the dollar declines, it can let the option expire.

Commodities

Firms that buy or sell commodities use options to protect against price changes. Commodities options are available for cocoa, coffee, sugar, orange juice, and cotton. Weather affects these crops, so businesses want to fix the price and reduce risk.

Bonds

Bond options may protect against rising interest rates. Bonds' values fall when interest rates increase.

How To Trade Options

You trade options on the options market. Stock options trade on a number of exchanges, including the Chicago Board Options Exchange or the International Securities Exchange.

You must set up an account at a financial services company or work with a brokerage firm. The firm will evaluate your financial position and experience before approving you.

Before doing so, the Securities and Exchange Commission recommends you read "Characteristics and Risks of Standardized Options" and other material provided by the Options Industry Council.

There are three ways to buy options:

1. Hold them until maturity and exercise them at the strike price. You'd do that if you held a call option, and the price of the underlying asset rose above the strike price. Your profit would be the sales price of the asset minus the strike price, the premium, and the commission.
2. You could trade the option before the expiration date. You'd do that for a profit with call options if the underlying asset price rose above your strike price and you don't think it will go much higher. The reverse would be true for put options.
3. You could let the option expire. You'd do that if the asset price never rose above the strike price. You would only be out the premium and commissions.

The only time you would sell an option is if you already own the underlying asset. That's called a "covered call." With a "naked call," you don't own the asset. It's very risky.

Weekly Options

In 2005, the Chicago Board Options Exchange created weekly options contracts ("weeklys"). There are more than 600 types of contracts available (as of October 2021) on stocks such as Apple and Meta (formerly Facebook), indices such as the Russell 2000, and exchange-traded funds such as United States Oil. Hedge funds and other traders buy them to wager on short-term events. Others sell them to raise cash, collecting thousands of dollars in premiums each week.

As long as they are on the right side of the trade, weeklys won't affect the market. In a crisis, they could increase the volatility of a stock. The option owners might be forced to purchase millions of shares to cover their options.

The Best Options Strategies

The best options strategy depends on your goals. The Options Industry Council lists dozens of strategies. You would use some of them if you were bullish, and others if you were bearish. There are options to hedge stock price swings and others to produce income. For all trades, the Options Industry Council recommends that you be clear on an exit strategy before trading any option.

The Balance does not provide investment advice. Options trading is considered speculative with high risks of loss of principal. This article should not be considered advice or a strategy for trading. Please speak with a financial planner regarding investments.