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How Stock Options Work

How Stock Options Work

| January 20, 2024

If you’re a new investor, you might be getting used to the ins and outs of buying and selling stocks. You may hear the term “stock option” and wonder what it means. 

The world of stock option trading has its own special terminology that can be confusing to anyone just getting started in investing. Here is what you need to know about stock options, the language surrounding them, and how those options work. 

What Is a Stock Option? 

A stock option is a contract that gives an investor the right, but not the obligation, to buy or sell a specific stock at a predetermined price during a specified period of time.  

Options are based on the price of the underlying stock. Because options derive their value from the underlying stock, they are often referred to as equity derivatives or equity options. 

A stock option’s price — called the strike price — is related to the market price of the stock to which it refers. So when that underlying stock price moves up or down, it impacts the price of the stock option. 

The contract, or agreement, for one stock option is equal to 100 shares of the specific stock. 

Buying and selling stock options is done on several public stock exchanges, such as the Chicago Board Options Exchange, the Boston Options Exchange, the Philadelphia Stock Exchange, and the International Securities Exchange, among others.  

Stock Option Types 

There are two types of stock options: a call option and a put option. 

With a call option, the buyer has the right, but not the obligation, to buy a stock at the price the investor sets. The value of the call option increases when the price of the underlying stock rises. 

With a put option, the buyer has the right, but not the obligation, to sell the stock short. The value of the put option increases when the price of the underlying stock falls. 

While an investor with a buy call has the right to buy 100 shares of stock at a certain price, and one with a buy put has the right to sell 100 shares of stock at a certain price, the person holding the sell call must sell 100 shares to the buy call and must sell the 100 shares to the buy put. 

Stock Option Styles 

The two stock option styles are American and European. These terms are not actually related to any location. Instead, the style of stock option determines when the agreement will be fulfilled. 

The American style allows an investor to exercise the stock option at any time up to the expiration date. With a European-style stock option, which is less common, the option can only be exercised on the expiration date. 

Contracts can expire in a week, a month, or a year — or more. The expiration, or maturity, dates of contracts typically fall on the third Friday of a month. However, the agreements now can expire on any day that a monthly contract doesn’t expire. 

Stock Option Class and Series 

The stock option class is made up of stock options with the same type and style and the same underlying stock.  

An example of a stock option class could be American style with a call on stock XYZ. The stock option series just extends the stock option class to include the strike price and expiration date. So, this example looks like this as a stock series: American style with a call on stock XYZ, expiring in January with a $50 strike price. 

How the Overall Process Works 

How do stock options work exactly? If you’re an investor and you believe the price of XYZ stock, at $100 now, will rise in three months, you can buy a call option with a strike price of $130 for three months in the future. The strike price is the price the stock must rise above for you to realize a profit. 

This means that, as you approach the third month, the price of stock XYZ rises to $160. You might decide to exercise your call because the stock is now worth $30 more than the strike price. You also could profit from a put option if the price dropped below the strike price by the maturity date. 

Find a Financial Professional Today 

Investing in stock options can be a lucrative but complex undertaking. To minimize your risk and ensure you have the best chance of success, it’s vital to partner with a skilled financial advisor. The team at Good Life Financial Advisors of Morehead City is dedicated to helping clients reach their financial goals.  

To schedule your no-obligation discovery meeting, contact us today.