What Are Options and How Can They Produce Big Gains?

An option is a contract that is sold by an option writer to a buyer who then becomes the option holder.

An options contract gives the holder the right to buy or sell an underlying security at a specified price by an expiration date. However, the holder is not obligated to buy or sell the underlying security.

For example, if an option is sold for Company ABC’s stock, then the buyer, also known as the holder of the option, pays a premium to the seller, who also is the option writer. The holder then has the right to buy or sell Company ABC’s stock before expiration at a set price that is known as the strike price, regardless of the current market price of Company ABC’s stock.

Options offer an opportunity to produce a large profit for an investor, but they also can be very risky. It is important to know what options are, the different types of options and the strategies used with options. That knowledge will better equip investors to profit from options.

Options are a financial derivative; this means that the price of an option (the premium paid by the buyer to the seller) is derived from the value of an underlying security (e.g. stock). As the price of a stock changes, the option premium for that stock changes, too. Volatility, which measures the fluctuation of an underlying asset’s market price, is a big factor on option prices. Generally speaking, a higher volatility means a higher option price. This relationship is important in determining whether to buy or sell an option.

Another important note in options trading is the fact that there are two main types of options: call options and put options. In both options, you either can be the holder or the writer of the option. If you are the holder of a call option, then you have the right to buy an underlying asset at a strike price by an expiration date. You would do this if you believe that the market price of the underlying asset is going to rise. The holder of a put option then would have the right to sell an underlying asset at a strike price by the expiration date. This strategy makes sense if an investor expects the market price of the underlying asset to fall. Consider the next two examples and strategies.

Examples:

• Profiting as a holder of a call option: Company ABC has a price per share of $98. Investors who think stock ABC will rise could choose to buy one call option with a strike price of $100 expiring in one month. The investor would have the right to buy 100 shares of Company ABC at a price of $100 until the expiration date. One option contract equals 100 shares of underlying stock. If the premium for the call option costs $3 per share, the price is $300 for one ABC call option. If the share price of Company ABC rises to $105 within the month, the call option can be exercised to buy 100 shares of stock at $100 for a total of $10,000. The investor who exercises the call option then immediately may sell it for the market price of $105 to produce a profit of $10,500 – $10,000 – $300 = $200. However, if the share price never rises above the strike price, then the call option expires, and the buyer of the option loses the $300 paid as a premium to the option writer.
• Profiting as a holder of a put option: Company ABC has a price per share of $102. If one put option is purchased for stock ABC with a strike price of $100 and an expiration date in one month, it is a bet that the share price will go down. The put option then offers the right to sell the 100 shares of ABC at a price of $100 until the expiration date. Let’s assume the premium for the put option costs $2 per share and an investor pays $200 for one ABC put option. If the share price of ABC drops to $95, the put option could be exercised to buy 100 shares of stock at $95 for a total of $9,500, then sell the shares back to the option writer for the strike price, $100. This generates a profit for the buyer of $10,000 – $9,500 – $200 = $300. However, if the share price never falls below the strike price, then the put option expires to produce a loss of $200 for the premium paid to the option writer.

These are examples of strategies you could use to generate a profit when buying a call or put option.

For investors who sell a call or a put option, the profit comes from the premium received by the buyer. If the call or put option is not exercised by the holder of the option, then the option becomes worthless. In that case, the writer of the option is not obligated to pay the holder of the option anything and can keep the premium as a profit. If the market value of a stock (i.e. underlying security) is expected to fall, sell a call option. If the market value of a stock is expected to rise, sell a put option.

These are basic but effective strategies for buying and selling call and put options. When these strategies are effectively used, they can generate some serious profits.