Editor's Note: Options are not suitable for all investors. 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. Please see the Characteristics and Risks of Standardized Options.
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While most investors are familiar with buying and selling shares of stock directly, investing in options is another way to put money behind stock price movements.
Options are a type of derivative contract that allows the investor to buy (or sell) a stock, or some other asset, at a certain price within a specific time period. The two basic types of options are known as “puts” and “calls.”
Options trading is a strategy some active traders use because it offers the potential to make profits within a shorter time frame, as opposed to owning shares of stock outright and waiting for their value to increase over time. Options trading may potentially generate returns, but it can also amplify losses, making it a high-risk strategy.
Key Points
• Buying a call option gives an investor the right, but not the obligation, to buy shares of an underlying asset at a specific price and by a specific date, to potentially profit from a price increase.
• Buying a put option gives an investor the right, but not the obligation, to sell shares of an underlying asset at a specific price and by a specific date, to potentially profit from a price decrease.
• The buyer of a call or put option must pay the seller a premium for the options contract, assessed per share.
• The price at which an option can be exercised, as specified in the option contract, is called the strike price.
• Options trading involves risks, including potentially substantial losses.
What Are Options in Trading?
In options trading, an option contract is a derivative instrument that’s based on an underlying asset: e.g., stocks, bonds, commodities, or other securities. Thus, the buyer of an options contract doesn’t purchase the asset directly, but a contract with an option to buy or sell that security. For example, with stock options, also called equity options, one contract typically represents 100 shares.
There are two types of options, as noted above: calls and puts. The examples below focus primarily on stock (or equity) options.
Options Buyers vs Options Sellers
An options buyer, also called the holder, has the right, but not the obligation, to buy or sell the underlying asset at the agreed-upon price (the strike price) by a specific date (the expiration). Buyers pay a premium for each option contract, which is assessed per share. If there is a $1 premium per share, at 100 shares, the total cost of the option is $100.
The potential upside for the buyer could be unlimited, depending on their options trading strategy. And since an options buyer is not obligated to exercise their option — meaning to actually buy or sell the underlying stock at the price agreed to in the option contract — the most they stand to lose is the premium paid for the option.
An options seller, also called the options writer, is on the other side of the trade. In this case, if the options holder exercises the contract, the option seller has an obligation to buy or sell the underlying asset at the strike price.
The potential upside for an options seller is the option’s premium. Their potential downside depends on whether they’re selling a put option or a call option. More on this below.
Trading options requires familiarity with options terminology, since these strategies can be complex and come with the risk of significant losses, depending on the strategy.
Key Options Terminology to Know
Before getting into how calls and puts work, it’s helpful to become familiar with a few key options trading terms.
Strike price: The strike price is the price at which an options contract can be exercised. This is the price at which the underlying asset can be bought (for call options) or sold (for put options).
Premium: The premium is the price the options buyer pays to the seller for the contract. Prices are assessed per share, so a $1 premium on a standard 100-share contract would cost $100. The premium is the maximum amount a buyer can lose on the trade, excepting any transition costs.
Expiration date: The expiration date is the deadline by which the buyer must decide if they want to exercise the option. After that date, the contract ceases to exist.
In the money (ITM): A call option is in the money if the underlying asset’s market price is above the strike price. A put option is in the money if the market price is below the strike price.
Out of the money (OTM): A call option is out of the money when the market price is below the strike price. A put option is out of the money when the market price is above the strike price.
Exercise: To exercise an option means to use the right granted by the contract — buying the underlying asset (for calls) or selling it (for puts) at the strike price.
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How Does a Call Option Work?
When purchased, a call option gives the options buyer the right, but not the obligation, to buy 100 shares of the underlying asset at the strike price, by (or upon) the expiration of the contract.
Buying a call option can be appealing because it gives a buyer a way to potentially profit from a stock’s price increase without having to pay what could be the current market price for 100 shares.
If the price of the underlying asset rises above the strike price, then the buyer may choose to exercise their option, paying less than what the asset’s worth on the market and potentially selling the shares for a profit.
For a call option buyer, the potential profit depends on the premium they pay and if, and by how much, the price of the security rises above the option’s strike price before it expires. The maximum potential upside is unlimited since, theoretically, the price of the underlying asset could continue to rise. The maximum potential downside is limited to the premium paid for the option.
Conversely, the seller (or writer) of the call option has the obligation to sell the underlying shares to the buyer, if the buyer exercises the option. The seller’s maximum potential gain is limited to the option’s premium. Their potential downside is theoretically unlimited, since they must sell shares at the option’s lower strike price, no matter how high the market price has risen.
Example of Buying a Call Option
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 per share — meaning they only pay $1 up front — then the investor will only be risking $100, not the $4,000 that would be needed to purchase the shares.
If the stock is trading at $55 on or before the expiration date, it may 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 (minus any fees). In this case, the net profit would be $4 per share (or $400 total), calculated as the $5 difference between the $55 market price and the $50 strike price minus the $1 share premium paid: 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 enough in price, 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.
Recommended: A Beginner’s Guide to Options Trading
How Does a Put Option Work?
A put option gives the investor buying the contract the right, but not the obligation, to sell the underlying security at the agreed-upon strike price, by (or upon) the expiration date of the option.
If buying call options is a way to potentially profit when the price of a stock or other underlying asset moves in the right direction, buying put options can be a way to potentially 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).
The key difference between buying a put vs. a call option is that the put option becomes increasingly valuable as the price of the underlying asset decreases. A put option buyer is hoping they can sell the underlying asset at a strike price that’s higher than the market price.
For the put option buyer, the maximum potential upside is the difference between the option’s higher strike price and the price at which the option is exercised (minus the premium and any fees), while the maximum potential downside is limited to the premium paid.
Again, the put option seller is on the other side of the trade, and is obligated to buy the shares from the put buyer, if the buyer decides to exercise the put option. The put option seller’s maximum upside is the option’s premium. Their potential maximum downside is the difference between the option’s strike price and zero (plus any fees), since the lowest price that the underlying asset could fall to is zero.
Example 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 $50 to $35, the option is in-the-money and if they were to exercise the option, they could sell shares for $40 that are worth $35, pocketing $5 per share or $500, minus the $100 premium, leaving them with $400, minus any brokerage fees.
Call vs Put: Summary of Key Differences
Comparing calls vs. puts side-by-side can help clarify which strategy may be appropriate for a given market outlook.
| Call Options | Put Options | |
|---|---|---|
| Direction | Generally used when an investor expects the price of the underlying asset to rise (a bullish outlook) | Generally used when an investor expects the price of the underlying asset to fall (a bearish outlook) |
| Right granted | The buyer has the right to buy the underlying asset at the strike price | The buyer has the right to sell the underlying asset at the strike price |
| When the option gains value | Becomes more valuable as the price of the underlying asset rises above the strike price | Becomes more valuable as the price of the underlying asset falls below the strike price |
| Maximum gain for the buyer | Theoretically unlimited, since the underlying asset’s price could continue to rise | Limited — an asset can only fall to zero, so the maximum profit is the difference between the strike price and zero, minus the premium paid |
| Maximum loss for the buyer | Limited to the premium paid for the contract | Limited to the premium paid for the contract |
| Maximum gain for the seller | Limited to the premium received | Limited to the premium received |
| Maximum loss for the seller | Theoretically unlimited, since there is no ceiling on how high the underlying asset’s price can rise | Substantial but finite — limited to the difference between the strike price and zero, minus the premium received |
Risks of Options Trading
Options trading can be a useful way to manage risks in a volatile market and potentially profit from movements in stocks one doesn’t own. Again, an investor buying options only stands to lose the premium they pay for an options contract, though the cost of premiums can accrue if purchasing multiple options contracts over time.
However, an investor selling call options or put options, who is obligated to either buy or sell an option’s underlying assets per the terms of the options contract, could potentially see substantial losses. This is especially true if they are selling options contracts without owning the underlying assets (referred to as writing naked calls or naked puts) or don’t fully understand the potential downside to the trades they’re executing.
The Takeaway
Options may appeal to individual investors because they offer a way to potentially see a gain from movements in a stock price, without having to own the underlying shares. If an investor isn’t able to exercise the call or put option they purchased, they’ll lose the premium they paid for that contract. However, selling a call or put option can be high risk, potentially leading to significant losses.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
Is it better to buy a call or a put?
The right choice depends on a trader’s outlook on the underlying asset. Call options may be worth considering when an investor expects the price of an asset to rise, while put options may be more appropriate when an investor expects the price to fall. Both strategies carry risk, and investors should carefully consider their financial situation and risk tolerance.
What happens when a call option expires?
Options in the money may be exercised automatically and the buyer may receive either the cash equivalent of the difference in strike and market price, known as cash settlement, or the underlying shares at the strike price. If the option is out of the money at expiration, it expires worthless, and the buyer loses the premium paid for the contract.
Can you lose more than your investment in options?
The maximum loss is limited to the premium the options buyer paid for the contract. A buyer cannot lose more than the amount they invested in the option itself. Options sellers face a different risk profile: the seller of a call option faces theoretically unlimited loss potential, as there is no ceiling on how high the underlying asset’s price may rise.
Do I have to own the underlying stock to buy a put?
Investors can buy put options without owning the underlying stock. In that case a trader may potentially profit from a decline in the asset’s price without short selling the stock. Investors who do own the underlying stock may use a put option as a hedge, known as a protective put.
How are options premiums calculated?
Options premiums are determined by several factors. These include the current price of the underlying asset, the strike price, the time remaining until expiration, and the implied volatility of the underlying asset. Generally speaking, the more time remaining on a contract, and the greater the volatility of the underlying asset, the higher the premium may be. These variables shift constantly, so options premiums also change throughout the trading day.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
Options involve substantial risk of loss and the possibility an investor may lose the entire amount invested. Before starting options trading, investors should be familiar with the Characteristics and Risks of Standardized Options . TTax implications with options should be considered. Consult your tax advisor to understand any impacts to your taxes.
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