What are Stock Options?
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If you're familiar with the stock market, then you know it's a place where people can buy stocks, which represent ownership stakes in public companies like Apple and Amazon.
But what are stock options?
Definition of a Stock Option
First, the formal definition:
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. This is referred to ask the strike price. 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 you bought the option itself for, say, $10. 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 position for $105 per share (95+10).
If, at that time, the prevailing price for the stock is $110 per share, then you will have profit 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. We have a guide on how to trade options for beginners.
Imagine that you buy a call 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 suggests they have both more risk and potential reward than stocks can offer.
This means if you know ways to make money in the stock market, you might be able to amplify your results by using options.
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.
For call options, that's equal to the stock price minus the option's strike price.
For put options, it's equal to the strike price minus the stock price.
There is another component to an options valuation, which is its extrinsic value. 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.
How to Make Money with Options?
The key to making money is to use a profitable options trading strategy. Learning to do it on your own may seem daunting, but it's possible for many.
If you're not interested in trying to do it on your own, you can always get help from the pros. Rather than putting in the time and effort to become an options trading expert, you can lean on someone else who already is one.
You can consider an options trading alert service. You pay a fee to have professionals alert you when to consider buying and selling options.
It takes all the heavy lifting out of options trading, although it's not free. That's the tradeoff that you have to consider when deciding whether to get help from a pro.
The other way to get help from a pro is to take an options trading course. That allows you to learn the strategies and how to employ them profitably. It puts more of the decision-making in your hands.
Options are essentially a vehicle to make money in the stock market. They are correlated with stocks and offer more leverage than stocks.
There are a lot of mechanics involved in how options are priced, but you don't need to understand those to simply have an understanding of what an option is to begin with.