If you’re familiar with the stock market, then you know it’s a place where people can buy and sell stocks (which represent ownership stakes in public companies like Apple and Amazon).
But what are stock options?
First, the formal definition: stock options give someone the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date.
If that sounds a bit confusing the first time you read it, then you’re like every other human who has ever tried to understand it for the first time.
Example of a Stock Option
We’ll try to make it easier by sharing this example of a stock option:
Apple $95 Strike Option December 5
Let’s break this down. The first part specifies the stock that the option is for (in this case Apple).
The second part specifies the price at which you can buy the stock when the option expires. In this example, the option would allow you to buy Apple stock at $95 when it expires.
The last part specifies the date by which the option expires (in this case December 5).
So imagine bought the option itself for, say, $10. And if you hold the option until expiration, you know you will be able to buy the stock for $95. That means that at expiration, you will be into the stock $105 per share (95+10).
If, at that time, the prevailing price for the stock is $110 per share, then you are in a profitable position because you will have just secured the position for a discount of $5 per share.
One of the beauties of options is the leverage that they offer. This example offers evidence of that, since $5 per share of profit was made by investing just $10 per share to buy the option.
Stock Options Can Be Traded Like Stocks
An important thing to understand is that options can be traded like stocks. People do not have to hold options until they expire.
So imagine that you buy an option and then the underlying stock goes up noticeably in value way before the expiration date. You can turn around and sell the option before it expires and cash in on that profit any time you want.
Even when you sell options before they expire, they still give you a way to control a stock at a price that is much lower than the actual share price of the stock itself. This offers a lot of leverage which means they both more risk and potential reward than stocks can offer.
How Are Option Prices Determined?
Option prices are a topic that can be quite complex. The core component of value for many options is the intrinsic value, which is referring to the stock price minus the option’s strike price.
But there is another component to an options valuation, which is its extrinsic value. And that’s where things get more sophisticated. The extrinsic value can be affected by a host of factors, including time until expiration and the volatility of the underlying stock.
If you like the idea of using options as a vehicle for investing, you can consider Mindful Trader’s options picking service. The guy who runs it is a Stanford grad who spent years doing stock market research, and he points out the exact options he’s trading based on that research.