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Understanding Stock Options

Most of us know that investing is a key to building wealth. But the stock market and other investment markets can seem very confusing at times. Among other things, there are those strange investment contracts that are referred to as “options.” What are stock options? What is the difference between a put option and a call option? And how are options different from short-selling and other stock maneuvers? Here’s what you need to know.

Stock basics: a refresher

First things first: stocks and other investment vehicles are things you can buy that — ideally — increase in value over time. Stocks represent shares of a company. They’re slightly different from ownership shares in some legal ways, but you can think of them as being quite similar. When a company does well, it’s worth more to have a share in it, and the stock goes up. Stocks may also rise and fall based on expectations and speculation.

When you buy a stock, you’re usually hoping that it will increase in value. But stocks also go down, of course. Stock options offer ways to limit risk while betting on or against a stock.

What is a stock option?

Stock options are similar to a contract that gives the bearer the right to buy or sell a stock at a certain price within a certain time frame. Generally, stock options are priced by the right to buy or sell 100 shares. A ten-cent option to buy a stock, then, will generally mean you’re paying ten cents for the right to buy 100 shares of the stock within whatever time frame is stipulated by the contract.

Options can limit risk for investors. If you want to bet on a stock rising, you can buy it, but that can be expensive. And if you’re wrong, you’ll lose a chunk of cash. If you buy an option instead, you could lock in a low price on the stock. If it rises as expected, you can then buy it for that price. You’ll make a bit less than you would if you’d made the regular bet (since you’ve paid for the option, as well), but you’ll have faced less risk: if the stock had dropped, you could decline your option and lose only what you paid for the option, rather than being stuck with a plummeting stock you paid top dollar for.

You can also limit risk when moving in the other direction. If you think a stock will drop, you can “short” it by agreeing to a sale at a given price at a certain point down the line, even if you don’t have the stock yet. If the price drops, you can buy it for less and immediately make the agreed-upon sale for more. But if the price rises, your losses can be unlimited. Options can make this process safer. You can buy the option to sell the stock at the price in question, rather than agreeing to do so no matter what. Once again, your profits may be a bit more limited, but your risk will be much lower.

Types of stock options

We’ve already covered two types of stock options. With one type, you get the option to buy a stock or other investment vehicle. With the other, you get the option to sell. These are called “put” and “call” options.

To briefly recap call option vs put option specifics, a put option is when you have the right to sell a specified investment for a specified price within a specified time frame. This type of option is useful when you think the investment’s price is going to go down. A call option, on the other hand, is when you have the right to buy a specified investment for a specified price within a specified time frame. This type of option is useful when you think the investment’s price is going to go up.

Using stock options as part of a sensible investment strategy

In the financial markets, risk is often tied to reward. The bigger the risk, the bigger the potential financial reward. Options offer a sensible way for casual investors, day traders, and professionals to make bets while limiting their losses.

Stock options can be a part of a sensible investing strategy. Remember to balance your risk and your assets. As an investor, it’s on you to do your research and protect your nest egg while doing your best to grow your wealth. For the best results, read up on trading strategies and financial news, or work with a trained pro— like a financial advisor—  to fine-tune your strategy! Good luck out there.