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How Do Stock Options Work?

Have you ever seen anyone make $2.4 million in 28 minutes? Believe it or not, it has been done before.

You may be asking yourself how is that even possible? Was it legal? 

It was completely legal, and the person was able to do this by utilizing stock options.

Stock options can be used in many different ways, from protecting your investment to generating wealth. You’re likely wondering — how do stock options work? Keep reading to learn how to utilize stock options and how they can benefit you.

What Are Stock Options?

Stock options give you the right to buy or sell a certain number of shares of a specific stock. The contract specifies at which price you will be buying or selling, and sets a specific time when it can be exercised.

Stock options trade much like stocks traded on the market (Apple, Tesla, Amazon, etc.) You pay a premium to give yourself the right to purchase or sell the underlying equity. The premium is the price that it costs for one contract, and one contract is equivalent to 100 shares. So stock options must be bought in 100 share blocks.

If you are looking for low capital investments, stock options are worth checking out. They can produce great returns and can also be used to hedge an existing position that you would like to protect.

Many companies give employees stock options as a form of incentive.

The price of the stock option is called the grant and is normally the price that the stock is at when the option is purchased. Employees make money from these options as the price of the underlying stock increases, giving them the “option” to purchase the stock at the lower grant price. The employee can then sell the shares at the current market price and retain the difference. 

Major technology companies have been giving stock options to employees for some time now. This is done to help preserve cash while also giving employees an incentive for the future growth of the company. 

How Do Stock Options Work?

The price of the stock option normally correlates to the price of the underlying stock or equity. As the price of the underlying stock increases, the price of the option for that stock will also increase and vice versa.

When purchasing a stock option, you pay a premium to give yourself the option to purchase or sell the underlying stock. The price of the premium is determined by two things:

  1. How close your strike price is to the current market price (referred to as the intrinsic value)
  2. The volatility of the underlying stock (referred to as the Implied Volatility)

The strike price is the price at which you can exercise the stock option. The implied volatility refers to the likeliness that the market is predicting the stock will increase or decrease. 

Stocks that tend to have wild swings will have a higher premium to pay, as it is more likely that the underlying stock will reach the strike price that is in the contract. Stocks including Tesla, Apple, and Roku, among others, normally have higher premiums because they tend to see some of the biggest swings in their share price. 

If a stock is expecting to have a news release, the implied volatility for the stock will also increase, in turn increasing the premium for the stock option. An example of a news release that would increase the implied volatility would be a company that is expecting a good earnings report, or a pharmaceutical company getting FDA approval of a drug. 

To determine a fair strike price, it is helpful to know where the stock has been trading in past times frames. Some of the popular time frames worth checking would be:

  • The last day
  • The past month
  • The past 3 months
  • The past 6 months 
  • The past year
  • Year-to-date
  • And even higher time frames like 3-10 years

It is important to know where the stock has been in the past because it is usually a good indicator of where it will be in the future. To determine this, it is recommended to look at past “channels” or prices the stock normally stays in between.

If the stock is in a rising channel, it is fair to assume it will continue in that pattern unless something is expected to happen that will negatively impact the price of the stock. This could include a negative press release, bad earnings numbers, lowered guidance, etc. 

Stock options can be used for bullish (expecting the price to increase) and bearish (expecting the price to decrease) expectations. There are two types of options available:

  • A call option – This gives you the right to buy a certain stock or equity at the strike price you agreed upon. 
  • A put option – This gives you the right to sell a certain stock or equity at the strike price you agreed upon.

Call options can be used for many things like growth and speculation for income. Put options are great for hedging a position you already have in a certain stock and can be used for speculation a stock price will fall as well. These options may be used in conjunction with one another to make combination strategies. 

Example of Using a Stock Option

For example, Apple stock is currently trading at $200. You believe this is a fair price for the stock and speculate that the stock will continue to increase, and you decide to buy a call option.

You purchase a call option with a strike price of $205, and the expiration date is a month away. The premium paid for this option is 20 cents. Since the contracts only come in 100 share blocks this equals out to 20 dollars (.20 X 100).

Say the stock goes to $210 within the month. If you decide to exercise your option, it would be worth $5. And since they are only bought in 100 share blocks, $5 times 100 equals out to $500. You only paid $20 for the option, so your profit would be $480.

Stocks do not always go the way we expect them too, that’s why it is recommended to use caution with stock options. If the price does not go above the $205 strike price by the end of the month, your option will expire and become worthless.

For More Information on Stock Options

So, how do stock options work? Now, you should have a good foundation of knowledge. Stock options are only advised for experienced investors who have thoroughly researched their investments. When used properly, they can be great tools to generate income and protect your existing stock positions.