What Are Options? - SmartAsset

An “option” in the finance world entitles the holder of the option to buy or sell an asset at a pre-determined price, on or before a certain date. The buyer pays a premium for the option, and may lose that initial investment depending on how the stock performs. If that sounds confusing, fear not. We’ll break it down for you in our guide to options. If you need help picking an investing strategy, a financial advisor can help you create a plan for all of your investing needs and goals.

What Is an Option?

An option is a financial instrument that people invest in. If you buy an option, you’re purchasing the right to buy or sell an asset (usually a stock) at a certain price and in a certain time frame. The seller must let you exercise that option. The buyer of an option pays a premium for the privilege of having the option to buy or sell at a predetermined “strike price” on or before a certain date.

The investor’s initial outlay is that premium multiplied by the number of shares at stake. Let’s break down a simple example. If the premium on an option is $4 for 100 shares, then it will add up to $400. Now, assume that this is a call option, which entitles the purchaser to buy stock and not sell it. The strike price in the contract is $80, and the maturity date is one month later.

At some point on or before that date, the stock is trading higher, at $90, meaning the investor is up $10 per share ($90-$80). The options are “in-the-money” by $10. Multiply that by 100 shares and you’ve got $1,000. Subtract the initial investment of $400 and you’ve got a tidy $600 (not including commission and fees).

If those shares had decreased in value, our hypothetical investor would be out $400. The options would expire “out-of-the-money” and be worthless. That’s the risk you run when you dabble in options.

Types of Options

There are two different types of options and it’s important to understand how each works. The difference between the two relates to how the option is used by the investor to make a return. The two different types of options are:

1. Call Option

The most common form of option, and the one described above, is a call option. A call option is an option used for buying, not selling. The buyer of the option is hoping that at the time he or she “calls” the option, the price of the stock will have risen beyond the strike price. That way, the agreed-upon price the buyer pays will be lower than what the stock is worth.

When you bet that a stock will be increasing in value, you’re “going long” on that stock. You can then: a) exercise your option to buy the stock and either hold it or turn around and sell it on the open market or b) close out with the entity that sold you the options. When you close out (also known as “trading out”) you perform what’s called an offsetting trade by selling the option you originally bought. You never actually own the underlying asset.

2. Put Option

A put option is an option that gives the buyer the right to sell (not buy) an asset in a certain time frame. It’s the counterpart to a call option. As you might expect, the buyer of a put option is hoping that the stock price will have decreased since the original contract date. If it has, the buyer of the option can sell the stock for a higher price than the stock is now worth. This is one way of “shorting” the stock or betting that its value will drop.

As an example, assume that an investor has one put option on a stock that is currently trading at $150. If the strike price is $140, and it expires in one month, then the investor would have the right to sell 100 shares of that stock at the price of $140 by the expiration date.

So if the shares of that stock fall to $130, the investor could execute a short sell position before the deadline at $140. In this case, they would make $1,000 (100 shares x (the strike price of $140 – the trading price of $130) on the put option. The investor would then need to deduct how much they paid for the option and any commission costs to get the net profit.

How to Trade Options

Options are traded on major exchanges and the options market is regulated by the Securities and Exchange Commission (SEC). You’re likely better off trading regulated options as opposed to trading over-the-counter (OTC) unregulated options or gambling on binary options. To enter the regulated options market, though, you’ll need to go through a brokerage firm. The broker will handle your options contract. You can check options tables online to find out how you’re doing.

Ready to go try your luck on some options contracts? Not so fast. If you want to enter the options world as an individual (“retail”) investor you’ll be required to submit an application first. Why? Because options carry very serious financial risks and regulators don’t want ordinary people getting in too deep. In your application, you’ll need to answer questions about your investing experience and knowledge.

Pros and Cons of Option Trading

It’s important to understand how options can benefit your portfolio before you make a trade or accept any options. Here are the pros and cons that options trading can provide to your overall investment portfolio.

Pros

Low Risk: You don’t have to commit the full capital to the investment when you buy an option as you would if you owned stock outright. This creates a lower level or risk for the investor.
Can Be Used to Hedge: You can use options trading as an opportunity to hedge your bets against other investments that you’re more fully invested in. This protects your portfolio from a potentially massive loss without committing more capital.

Cons

Can Be Complicated: If you’re not an active investor, and you don’t have an advisor, then investing in options can be risky. They can be complicated to understand and know if you’re profiting when you exercise your option in many circumstances.
Sellers Can Take Huge Losses: Options can expose a seller to incur big losses that are greater than the price of the option contract.

The Bottom Line

Options can give investors the opportunity to buy or sell an asset at an established price and date. Experts say that novice investors could benefit more from buying and holding onto low-cost index funds. But if you are interested in trading options, weigh carefully the risks that will impact your investment.

It’s a good idea not to commit to a broker without checking SEC and Financial Industry Regulating Authority (FINRA) records for the broker’s licensing and any history of disciplinary action. Read through the broker’s application closely and answer honestly. And it’s also a good idea not to bet the house on an options contract. Any money you spend on options should be “fun money,” not the down payment, the bill-paying money, the emergency fund, the college fund or the retirement savings.

Investing Tips for Beginners

If you want to create an investing plan, a financial advisor can help you set and reach your investing goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
How much you invest depends on how much risk you can take, and how long your time horizon is. Our asset allocation calculator will help you align your investing strategy with your risk tolerance.
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