Stock options are the right to purchase or sell stock at an agreed price. These can be seen kind of like contracts to buy or sell 100 shares of a company’s stock. Usually named call options and put options. Buying an options contract won’t force you to buy or sell 100 shares of a stock unless you chose to exercise it. Sometimes the prices won’t make sense and this is called a options contract that expires “worthless”.

Call Options Explained

The market makers will release these contracts on stocks they own “betting” that a stock will not go over that price. You buying these contracts is the converse. You expect the shares to go up further than what the market makers predict.

For example, stock XYZ is $30 a share. A market maker makes a call option for a $50 stake price (they are betting it won’t go over $50) and is selling the premium for $2 and is set to expire a year from now. Usually you have to multiply this number by 100 shares so the price of the contract would be $200. By some miracle you think this company will far surpass the $50 stake price. So you buy the contract for $200.

In order for you to break even the stock has to go above $52 because ($2 profit x 100 shares – Contract Price). This call option gives you the right to purchase 100 shares of XYZ at $50 no matter what. If the stock is $52 or $90 with this contract you can exercise your right to purchase 100 shares at $50

The potential to make money is infinite at this point. But realistically speaking a company to go from $30 to $50 is pretty rare. It would be a huge increase in market cap. It has happened before but keep in mind that is a drastic jump.

Let’s say in this hypothetical scenario XYZ reached $60. If you’re satisfied with that you can either exercise your option or sell it for a premium. If you do decide to exercise you can or your broker can lend you money to quickly buy 100 shares at $50 and sell them at $60. resulting in a $1,000 (10×100) profit. Remember you paid $200 for this contract so it would be a net profit of $800.

In another theoretical scenario option prices fluctuate every day with demand and with people looking for contracts. You are more than welcome to sell your contract if you want to get out or if you are happy with the current price. For example let’s pretend you just had a good feeling about XYZ and 10 days later the news reports XYZ is having record profits. The demand for your contract just went up. Let’s say it’s selling for $5 now. You can go ahead and sell it for $500 and net yourself a nice $300 profit. This can be done at any time as long as the contract is not expired.

Now for the bad scenario. Let’s say you waited all year and XYZ never even broke past $35. Your contract expires next week. You can either sell it for pennies on the dollar, or let it expire worthless. In this situation nothing will happen. You will just be out $200. You aren’t forced to exercise the option since there is no logical reason to. (Also you can write off this $200 loss on your taxes)

Put Options Explained

Put options are an opposite play to call options. This time it’s the right to sell a stock at the stake price. The market makers bet that this stock will never reach a lower price. Let’s use the XYZ $30 example. A market maker makes a contract for a $20 stake price. You think XYZ is doomed and they are going to do way worse than that. Same as call options they have a contract price. Let’s say it’s the same $2.

In order for you to break even here XYZ has to go below $18. You will buy the shares for $18 and sell them for $20. Resulting in a $200 (2×100) profit. Again no matter what price XYZ is you can sell it for $20. Opposed to call options the potential to make money is less since you cannot have a negative share price.

So hypothetical scenario for puts would be if XYZ was at $10 and you have a $20 put option. You can exercise that option and buy 100 shares at $10 and sell them for $20. Resulting in a $1,000 profit. Again $800 net after the contract price.

Sell the put option if the prices are to your liking. Like call options.

Or another scenario would be XYZ goes up instead. You can let the contract expire or sell it for cheaper than what you bought it for.

What Options Are Not

Stock options are not a way to get rich quick. They are very risky ways to make money. Especially if you don’t know what you’re doing. They are a good strategy to add on to your investment portfolio if you have the capital to dispose. Especially if you have high (or low) hopes for these companies. In my personal investing experience I had both my ups and downs, and it was all based on luck. This is just the basics on stock options, but there are more advanced strategies that use options which can be learned in a later chapter.

Thanks again for reading and see you next Sunday,
– Pablo