How Do Stock Options Work? Part 1: The Basics

Stock options have been marketed as portfolio insurance, a way to turbocharge returns, or a way to make money no matter which way the stock market moves. How is this possible? 

Stock options can be confusing to many investors because they can be used to make bets on a wide variety of market outcomes. In Part 1 of this series, I’ll explain how stock options work and how they are valued. In Part 2, I will describe some common stock option strategies. Finally in Part 3, I will explain why I do not recommend using stock options in your portfolio.

Stock Options Defined

A stock option is a contract that gives the buyer the right (but not the obligation) to purchase a stock at a certain price by a certain date. There’s a lot of information in one sentence so let’s break it down phrase by phrase:

1. A stock option is a contract…

A stock option is an agreement between the buyer and seller of that option. They are one of the simplest financial derivatives. They are called derivatives because their value is derived from the price of its underlying stock. The buyer pays money to purchase the option, and the seller receives that money to sell the option.

2. …that gives the buyer the right (but not the obligation)…

If you buy a stock option, you do not have to purchase the stock. You can choose to purchase the stock only if it is financially advantageous. If it is not beneficial to purchase the stock, you can let the option expire. This makes it different from stock futures, where the buyer must purchase the stock at the expiration date.

3. …to purchase or sell a stock…

Options to buy stock are called call options, while options to sell stock are called put options.

4. …at a certain price…

When the option is exercised, the buyer of the contract buys the stock from the seller at a pre-agreed price (called the strike price)

5. …by a certain date.

In the United States, the buyer of a stock option can exercise his right to purchase the stock at any time on or before the expiration date.

Other Common Terms Used With Stock Options

• Strike: the pre-agreed price that the buyer of the stock option can purchase the stock from the seller
• In the money: a stock option is “in the money” when the current stock price is less than the strike price
• Out of the money: a stock option is “out of the money” when the current stock price is greater than the strike price
• Exercise: when the buyer of the stock option elects to purchase the stock from the seller at the pre-agreed strike price.
• Delta: the change in value of the stock option if the stock price rises by $1.

An Example

I would like to purchase a call option to buy Apple stock (February 7, 2017 closing price: $131.53) at $135 by March 17, 2017. The price of this option is $1.00 per share.

If AAPL is trading at $150 on March 17, 2017, I could exercise my right to purchase 1 share of Apple for $135, and then immediately sell it at $150. Taking into account my original option purchase price of $1, I would have made $14.

However, if Apple is less than $135 on March 17, 2017, I would choose to let the option expire worthless. It would be cheaper to buy the stock on the open market for less than $135 than to exercise my right to purchase Apple at $135. In this scenario, I would have lost only $1.

The value of the stock option on the day of expiration (March 17, 2017) is shown on the graph below:

But how did the market value this call option at $1 on February 7th?

What Determines The Value Of A Stock Option?

The valuation of stock options prior to expiration is a very complex mathematical problem. You can read the Wikipedia article if you want to learn more about the mathematical details. Three academics developed the Black-Scholes Model in 1973, winning them the Nobel Prize in Economics in 1997. Rather than bore you with the mathematical details, let’s take the five variables in the Black-Scholes equation and understand how changes in these variables would affect the value of the stock option.

1. Strike price: The strike is the pre-agreed price at which the stock can be purchased. Call options to buy shares at higher strike prices will be less valuable, while put options to sell shares at higher strike prices will be more valuable.
2. Current stock price: As the stock price rises, call options to purchase stock at the strike price will rise in value, while put options to sell stock at the strike price will decline in value.
3. Risk-free interest rate: With the $1 I used to purchase my Apple call option, I could have invested in a risk-free bond (e.g. Treasuries). The value of the option needs to account for the (small) risk-free interest rate I can receive in an alternative investment.
4. Time to expiration: With more time until expiration, there is more opportunity for Apple to rise significantly and earn me a large profit. Both call options and put options are more valuable with increased time until expiration.
5. Volatility of underlying stock: In my Apple example, I make $14 on a $1 bet if Apple rises to $150, but will lose only $1 no matter how far Apple falls. Therefore, my call option is more valuable if Apple has more volatility. I have the opportunity for big profits if the stock rises, but only limited downside risk if the stock falls.

Summary

These are the basics of stock options. In Part 2, I will describe some common options trading strategies. Do you have any questions about how stock options work? Have you ever traded options before? Bonus question: what does the picture at the start of this article have to do with stock options?