What are options?
Options provide the purchaser with an option to buy or sell an underlying financial security within a given time-frame, at a stated price. Options can be issued over a range of financial securities, including stocks, indices and foreign currency. On this site, we refer to options issued on equity stocks. However, the same concepts generally apply to options issued over other underlying financial securities.
An option is defined by a contract between the seller of the option and the buyer of the option. The buyer pays a premium to the seller for the right to buy or sell a set amount of stock at a specific price on or before a specific date. The buyer can choose to “exercise” their option and use it to buy or sell the underlying security, or they can sell their option back to the market and take a profit or loss prior to the expiration date of the option, depending on the change in the option’s value.
Example of an Options Trade
Let’s walk through an example. The option buyer believes Starbuck’s stock price is going to increase in the next week or two. At the time of the option purchase, Starbucks is trading at $85. She buys a call contract that gives her the right to buy 100 shares of Starbucks for $85. This is called an At-the-Money Call, because the strike price is the same as the stock price. Two weeks later, Starbucks is trading at $87 per share. She can 1) exercise her right to buy 100 shares at $85, or 2) sell the call contract for a higher price and make a profit.
Lower Capital Requirements
Each option contract is worth 100 shares of the underlying stock. For this reason, an options trader can trade underlying securities with less capital (amount of money in one’s brokerage account) than buying the actual stock. 100 shares of Starbucks at $85 per share would cost $8,500. 1 call option on Starbucks could cost around $200, depending on many factors. For more information on how options are priced, see Option Pricing.
Underlying Security – A company’s stock or ETF on which the option contract is based.
At-the-Money (ATM) – An option is at-the-money if the underlying stock’s market price is equal to the strike price of a call or put.
ETF – An exchange-traded fund. It is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds. There are ETFs for most industries, and for major groupings of stocks such as the S&P 500, Russell 2000, Nasdaq, and the Dow.
In-the-Money (ITM) – An option is in-the-money if the underlying stock’s market price is above the strike price of a call, or below the strike price of a put.
Strike Price – The price at which a call or put can be exercised.