Stock options are financial contracts. They are known—along with futures, swaps, and some other financial contracts—as derivatives because their value is derived from an underlying financial asset (think: options for stocks, futures for commodities such as oil and gas, wheat and precious metals, and swaps for currencies). 

Unlike the other derivatives, options don’t have mutual obligations for buyer and seller. A futures buyer must purchase the commodity from the seller, and the swaps buyer must exchange currency with the seller. An options buyer isn’t obligated to buy or sell the underlying shares. 

(These kinds of options are not to be confused with employee stock options, which companies sometimes give as a reward for performance or to ensure longevity with the company.)

What is options trading?

Options trading is the buying or selling of options, which have a value apart from that of the underlying shares.

Think of an option like a discount coupon you get in the mail, with an expiration date, such as a $3-off coupon at a local car wash. Use it or lose it. The difference is that stock options cost something.

Different types of options

Stock options come in two varieties: calls and puts. In buying an option contract, the investor is expressing a view about the stock’s prospects—call options are bullish, put options are bearish.

• Call options.

  This is an opportunity to buy shares. For example, an investor could buy 100 shares of ABC Corp. now at the market price of $50, or instead buy an option with the right to buy ABC at $52 a share within the next month. Let’s say the option costs $1 a share. The investor would be willing to pay $1, known as the premium, if they believe ABC will rise above $52. An option premium is an upfront cost and is not refundable.

• Put options.

  This is an opportunity to sell shares. A put option gives an investor the right to sell 100 shares of XYZ Inc., for example, at $58 a share, when XYZ currently is trading at about $60. Let’s say this option also costs $1 a share. If the investor believes XYZ is headed for a decline, the investor would pay the $1 premium now for the right to sell XYZ later for $58 even though its price has dropped to $56.

Call or put options contracts are typically issued in increments of 100 shares. So in the ABC and XYZ examples, the call option buyer and put option buyer each would pay $100 to the option seller. The premium is the maximum an option buyer can lose if the option expires.

The seller of the option, also known as the option writer, takes the opposite view: that ABC’s stock price will stay below $52, per the call option example, or that XYZ likely will keep trading above $60, in the put option example. In such a case, the buyer would let the option expire without exercising the right to buy or sell, while the option seller keeps the $100 premium.

The difference between options buyers and sellers

Option buyers want volatility in the stock price, because volatility increases the odds that the price will swing enough to make the option profitable to exercise—the option will be “in the money.” They look at a stock’s historical volatility, as well as its implied volatility, or the odds of the stock price moving enough during the option’s life to make it profitable. Higher implied volatility suggests higher odds of profitability.

Option sellers don’t want volatility, because if stock prices trade in a tight range with little volatility, the options won’t be exercised and would be “out of the money.

How options are valued

Intrinsic value

This is the difference between the strike, or exercise, price and the current stock price. If ABC shares are trading at $54, for example, and the call option’s exercise price is $52, the option has an intrinsic value of $2—it’s in the money.

Time value or extrinsic value

This is the time left before the contract expires. The longer the time to expiration, the greater the time value; it diminishes as expiration approaches.

The premium charged by an option seller reflects some combination of the intrinsic value and time value. The combined premium and strike price are always “out of the money” to some degree, above or below the current stock price. In other words, there’s no free lunch for options buyers; the stock price needs to move higher or lower before the option becomes profitable for the buyer.

The option premium fluctuates with the price of the underlying stock, and with the passage of time. The nearer to expiration, the lower the premium, because there is less time for the stock price to swing in the option buyer’s favor.

Sensitivity of the option’s price to both the stock’s price and the time to expiration are estimated by theoretical measures known as “Greeks,” because the measures are denoted by Greek letters such as delta and gamma. Traders and professional investors watch the Greeks to assess potential risks and opportunities in options.

How does options trading work?

To trade options, an investor can call a broker or do it online through their brokerage account. Many brokerages and investment companies allow investors to do options trading themselves.

Options price quotes can be seen on various public platforms and websites, such as Nasdaq or Yahoo Finance. The list of options (called the options chain) goes by month of expiration, and in each month, options expire weekly on Fridays.

Looking at the options of a specific company expiring on a certain date, investors can see that some calls are in the money—meaning they have strike prices below the current stock price. Sometimes, options that are in the money will be shaded in a different color to distinguish them from options that are out of the money—the strike price is higher than the current stock price.

Options vs. stocks

So what is the incentive to buy options instead of just buying or selling stock?

A key reason is that options require less money upfront, and the returns on a successful option trade can be much greater than trading the stock directly. This idea of using a small amount of money to magnify gains is called leverage.

Let’s use the ABC Corp. example again. Suppose that an investor is deciding whether to buy 100 shares of ABC at the current price of $50 a share, or to buy a call option with the right to buy 100 ABC shares at $52. The option expires in a month and costs $1 a share. Before the contract expires, ABC rises to $54 a share.

Here’s a comparison of the choices:

• The investor would need $5,000 to buy the shares outright, but only $100 to buy the option.

• If the shares rise to $54 a share, the investor would make a profit of $4 a share, or $400, by buying outright; the gain on the call option would be $2 a share, or $200—the difference between the current share price of $54 and the right to buy at $52. The net gain would be $100, after paying the $1-a-share option premium.

• Because the investor would spend $5,000 to buy the shares, the return on investment works out to 8% ($400/$5,000); for the call options, the cost is only $100, so the return would be 100% ($100/$100).
  

Advantages and disadvantages of trading options

The option buyer’s risk is limited. The most the buyer can lose is the premium paid if the option expires worthless. In fact, more than half of options buyers sell their contracts in the market before expiration as the odds of being in the money diminish. Only a small portion of options are actually exercised, and about a third of them expire with no value.

The option seller’s risk is potentially much greater. For example, if a seller of a call option on ABC at $52 doesn’t own 100 shares of ABC and the stock price soars to $152, the option seller would have to pay $152 for 100 shares and then sell to the option buyer for $52 for a loss of $100 a share. An option seller who doesn’t own the underlying shares is said to be “naked,” while a seller who owns shares is “covered,” or protected from losses.

How are options used?

Speculation

An investor could take a flyer on the direction of the stock price, without committing to immediate ownership of the stock. For example, an investor in October 2021 might be willing to buy a call option on Merck & Co., expiring in November, with a strike price of $90, betting that further good news will come about Merck’s new Covid drug, the first to be developed in pill form.

Hedging

An investor might try to protect against losses if stock prices are expected to decline by buying put options. Or if stocks are expected to trade in a tight price range and not increase, the investor could sell covered calls—options on stocks the investor already owns. If stock prices stay in the range and never rise above the call’s strike price, the investor keeps the option premium as income. Stock options are used more for hedging than for speculation.

Alternatives to stock options: Index and ETF options

Options are also available on indexes (such as the S&P 500 and the Nasdaq 100), and on major exchange-traded funds. One key difference is that options on ETFs trade like regular stock options—they can be exercised before the expiration date and option buyers can then own the underlying ETF. Index options are only based on a theoretical value of the index and can’t be exercised before expiration. They are settled only on the expiration date, for cash.

How are options taxed?

Options are subject to capital gains taxes, with the tax rate depending on whether the investor is a buyer or seller of options; duration of the option; and duration of the stock investment if the option was exercised.

The bottom line

Options give an investor the right, but not the obligation, to buy or sell a stock at a given price within a certain period of time. Their value is based on how close or far they are from the exercise price and how long before they expire. Options can offer potentially greater returns than stocks and can be effective hedges that protect or limit losses from adverse share-price moves. But they require more time and attention to be put to profitable use. As such, options may be more suited to active traders and fund managers than to small investors.