Options: What are they and how they work

Options: What are they and how they work


options trading is an alternative way for investors to invest in the performance of the security. Such as a stock or an ETF by trading options an investor attempts to capture the up or down movement of the security. While only investing a fraction of the cost it would take to own the actual security


For example, consider a stock that’s currently trading at $100. If you purchased a share and the price went up to $5. You would have a 5 per cent return with the right option contracts you get profit from the same jump in the stock price while only paying a  small premium that cost significantly less in the price of owning the stock. The ability to make more with less is one of the benefits of options trading. However, the potential for greater profits comes with greater risk of losses

To help you understand why let’s take a closer look at how an option contract works unlike a stock

when you buy an option contract you’re not purchasing the security itself instead, you’re purchasing a contract but gives you the right to buy/sell a security at a price before a certain date consider this example suppose there’s a coffee shop chain called stone kerb coffee stone kerb stock is currently trading at $50 a share an investor believes that the stock price of stone kerb will rise this investor considers taking advantage of this anticipated price movement by buying 100 shares of the stock but she is concerned about the initial capital requirement

Now let’s assume that there’s another investor he already owns 100 shares of stone kerb stock and plans to hold on to it for a while. He thinks the stock price will not increase much over the next few months. Both investors can utilize a call option. This type of options contract gives the buyer the right: to buy shares of stone kerb stocks at a set price called a strike price. At a set time called expiration. In this case, it’s $55 per share in four weeks time. Typically each standard option contract represents 100 shares so this one contract would give the buyer the right to buy 100 shares of stone kerb stock at $55 per share the buyer purchases the contract by paying the options premium the premium or price of the option is determined by several factors including the stock price time until expiration and implied volatility which is how much the stock is expected to move during the life of the contract this premium gets credited to the seller of the call options and helps to partially offset the original purchase price of the stock

For this example let’s assume the total premium is $100 our buyer pays the $100 as purchased the contract. Now let’s examine what could happen to this investment suppose our buyers instincts were right and stone kerb stock is now selling at $60 a share remember the call option gives the buyer the right to purchase shares of this dock for $55 a share the buyer could exercise the call and purchase 100 shares for $55 each and then sell them at market value for $60 each making a profit of $5 per share not including commissions because shares of stone curb have risen by $5 the buyers contract is essentially worth $500 if our buyers soulder contract she could potentially make around $400 in profit the value of her contract – the $100 Premium she originally paid for it as well as any commissions and fees while the buyers investment paid off things didn’t work out as well for the seller although he was able to collect $100 for selling the option he missed out on a portion of the stock depreciation because he was obligated to sell his stock at $55 per share

now let’s rewind suppose the stock moved in the opposite direction and is now selling for $45 a share on the last trading day prior to expiration the buyers contract gives her the right to purchase shares of stone kerb for $55 a share because no one would want to pay $55 for stock that’s selling at $45 in the open market the buyers contract will likely expire worthless the buyer is now on track to lose 100% of her initial $100 investment plus any trading commissions and fees for the seller the option expiring worthless is good news he still owns his shares of stock and made $100 selling the option although the value of his share is declined he was able to keep the option premium left any commissions and fees for selling the option

we keep in mind this is a simplified example the pricing of options is very complex which is why it’s important to educate yourself about options and their risks before you invest while the biggest change comes from the price of the underlying instrument with the contract represent there are other forces like time decay and implied volatility that influence options prices well we showed you one example options can be used in a variety of ways there are call options which we just saw that can be profitable to own if the price of a stock goes up and then there are put options which can be profitable to own if the price of a stock goes down calls and puts can also be combined in a variety of ways by buying and selling these options investors have the potential to make money when the market moves in any direction and create strategies with a variety of risk levels you’ve taken the first step in understanding options