You know what it means to invest in a stock: you buy shares, thinking that they will go up in value at a later date, at which point you might choose to sell them. If there are shares you already own that you think are going to lose value, you might sell them.
But there are other ways to put money behind the movements of a stock price. Investors can also buy and sell options, which are a kind of contract that allows the investor to buy (or sell) a stock, or some other asset, at a certain price. The two basic types of options are “puts” and “calls.”
Unlike shares of stocks, put and call options have expiration dates, at which point you no longer have the right to buy or sell the shares. Options trading is a popular strategy for day traders, because you make profits not by owning the underlying shares and patiently waiting for them to go up, but acting quickly with options that expire quickly.
Much like buying and shorting stocks, an investor can use options to express their view on whether the price is likely to go up or down.
What Is a Call Option?
A call option is a contract that allows an investor to buy 100 shares of an underlying stock or other security at a prearranged price (known as the “strike price”). A call option can be appealing because it gives an investor a way of profiting from a stock’s increase in price without having to pay for the full price of 100 shares. What one pays is known as the “premium” on each share, which is typically much less than the current price of the stock.
The profit from a call option is determined by both the premium an investor pays and whether they’re able to exercise the option—this means actually buying the underlying stock and the price agreed to in the option contract.
An investor can also sell their call option: as the price of the underlying stock rises above the strike price, the value of the option to buy will rise. By selling the option itself, an investor doesn’t have to take delivery of the underlying shares and can profit from the increasing value of the option itself.
The Basics of Buying a Call Option
Consider this example: If an investor buys an option with a strike price of $50 for a stock that’s currently worth $40, the option will be “out-of-the-money” until the stock rises to $50. If the premium is $1/share—meaning they only pay $1 up front—then the investor will only be risking $100, not $4000.
If the stock is trading at $55 on or before the expiration date, it would make sense to “exercise” the option and buy the stock for $50, thus giving the investor shares with built-in profit thanks to the difference between the strike price of $50 and the value of $55. In this case the profit would be $4/ per share (or $400): a strike price of $50 gives the investor the right to buy 100 shares of a stock worth $55, with a premium of $1 per share.
On the other hand, if the stock has not risen in price enough, the investor can just let the option expire, having only lost the price of the premium, rather than being saddled with shares they can’t profit from.
Many brokerages, including discount brokerages who offer their services to day traders and individuals, offer put and call options.
What Is a Put Option?
There’s a key difference in call vs put options: If call options are a way to profit from a stock going up in price without having to own the stock itself, than put options are a way to profit from the fall of a stock’s price without having to short the stock (i.e. borrow the shares and then buy them back at a lower price). Of course, in cases where an investor sells their option, the opposite is true: they would benefit from the opposite movement of the stocks.
A put option is a contract that allows someone to sell shares at a certain price at a specified time in the future. The seller of the put option has the obligation to buy the shares from the put buyer if they choose to exercise it.
The Basics of Buying a Put Option
As an example, let’s say a stock is worth $50 today. If an investor thought the stock’s value could go down, they might buy a put option with a strike price of $40. Let’s say the premium for the option is $1, and they buy a contract that gives them the right to sell 100 shares at $40. The premium, then, is $100.
At the time the investor buys the put option, it’s “out-of-the-money.” If the price remains above $40 until it expires, the investor will not be able to exercise the option and they will lose the premium. But if the stock has dropped from, say, $50 to $35, the option is “in-the-money” and they could sell it for an increased premium to someone else. If an investor were to exercise the option, they’d profit from being able to sell shares for $40 that are worth $35, pocketing $5 per share or $500, minus the $100 premium, leaving them with $400.
Risks of Options Trading
Option trading can be a useful way to manage risks or profit from movements in stocks one doesn’t own. They can also lead to large losses, especially if an investor doesn’t understand the potential downside to the trades they’re executing.
This is especially true if an investor starts selling call options or put options, putting them in the position of collecting premiums but obligating them to either buy or sell the shares in question at the options expiration date. Investing in options on margin—i.e. with borrowed money—can also be high risk. Some brokerages have tools to screen traders from making certain types of option trades in order to maintain the risk.
Option trades—call and put options—can be popular with individual or amateur traders because they offer a way to make profits from large movements in a stock without having to own the underlying shares. But by this same token, buying and selling options can also lead to paying premiums over and over with little or no actual payoff.
There are many ways to start investing in the stock market. SoFi Invest® Active investing lets members trade or invest in stocks and exchange traded funds without transaction feeds—costs that appear small but can eat into any trading strategy.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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