Are you wondering how do options work? If that’s the case, this is a good place to start.

In premise, stock options are contracts that provide purchase/sale rights to the buyer. But that’s a very simple way to look at it.

In this article, we will cover stock options with greater depth, as well as provide ample examples of how they work.

So if that’s something you want to know, keep reading to learn more.

Fundamentals of Stock Options: How Do Options Work?

As mentioned earlier, a stock option is a type of contract that provides the buyer with the right to purchase/sell shares of a company at a specific price within a certain period of time.

To provide context, you are the “selling” stock option now. The person who will be buying the stock options from you will pay a premium. Depending on the type of option, the premium paid out provides the buyer the right to purchase or sell the stock. 

It’s always easier to do one of the two: buy or sell, but never both. If the buyer chooses to buy or sell a stock before the expiration date, the buyer will be exercising their option. 

And as the seller of the option, you keep the premium, whether or not they made use of their right to purchase stock. Now let’s take a look at some of the common option types.

The Call Option

A call option is a great way to develop stable cash flow, as well as reduce the cost basis for companies that a person already has stock in. 

In premise, a call option is a contract that provides the purchaser the right to buy stock or any other asset from the seller at a pre-determined price within a certain period of time.

How Do They Work?

The best way to understand call options is to make use of an analogy. For instance, you can think of it as a coupon that someone would take to a supermarket when buying their groceries at a lower price.

However, in the case of a call option, instead of taking a coupon from an advertising pamphlet, they would pay the supermarket a fee to have the coupon for themselves.

So the parties involved are the buyer and supermarket. The buyer of the coupon will retain the right to buy their grocery at a certain price. If the buyer chooses to make use of this right, the supermarket is obligated to sell them the product at that price.

Whether or not the buyer purchases the grocery, the supermarket will get to keep the fee that the buyer paid out for the coupon.

So if you bought a call option, you have the right to purchase underlying stock from the seller at the specific price during a specified time frame. If you are the seller, you are obligated to sell the stock at the specified price. 

The Put Option

The put option is basically the complete opposite of the call option. In this contract, the buyer buys the right to sell the stock to the seller at a pre-determined price within a specific time frame.

With a naked put, one does not need to short the underlying stock. When you sell your put option, you are willing to buy a stock at a price that is lower than that of which you are selling for currently.

While waiting for the price to get lower, you will earn some income, and when the price does come down, you will be happy to buy again at a lower price than sold.

How Do They Work?

The put option increases in value as the underlying stock and its price decreases. Selling naked puts is a great way to earn money when you are definitely sure of the value of the business.

However, the only problem with using naked puts currently is that you might have to buy the stock at greater prices than that of which you are selling your stock.

A put option becomes more valuable as the price of the underlying stock decreases.

For instance, XYZ is selling their stock for $40 a share. You like it at $30, so you sell an option for somebody to sell their stock at $30. They pay you $1 for the option. 

Then the stock starts tumbling down to $20. The option holder will require that you buy the stock at $30. 

And because of the option, you are obligated to do so, so you’re stuck for 30% devaluation. 

Buying Stocks vs Trading Options

You purchase and sell options on an exchange, similar to how you would purchase and sell stocks regularly. However, there are some very distinct differences that are worth noting. 

For instance, the main difference between the two is that stocks will provide you with minuscule ownership of the company, while an option is simply a contract that provides you with buy/sell rights upon a stock.

Another difference is that option trades are not great for the long-term, and as many investors vividly speak out about stock, they mention that if you buy stocks, you should plan to hold on to them.

By the merits of their character, options are risky. However, the market will establish exactly how much risk is involved. In any case, you simply need to find trading strategies that work.

Stock Reviewed

We’ve answered the question of “how do options work?” so, now, you are well on your way to try making use of them if you deem so appropriate. In any case, it’s your money and your risk, so do what you must.

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