In the financial markets, options provide the right, but not the obligation, to the contract holder or investor to buy or sell assets. In the most basic terms, a stock option means that you can place bets with your broker that the price of a certain stock will rise or fall.
In this article, we explained the basics of options trading. Here we take a closer look at options on stocks.
Basic definition of stock options
One of the most popular version of options is called stock options - often simply referred to as options - where the underlying asset is a stock. A stock option contract is an agreement between two parties that gives the buyer the right to buy or sell underlying stocks in a company at a predetermined price, called the strike price, within a specific time frame. This allows the trader or investor to speculate on the stock price rising or falling within a specific time period, until the expiration date.
A stock option contract typically represents 100 shares of the underlying stock. Options may also be written on other underlying assets, such as currencies, commodities, but the stock option is probably the most popular in this category.
Another type, the index options give an investor the right to buy or sell an underlying stock index, which comprises a large basket of stocks. These options may be tied to the price of indexes, such as the S&P500.
Institutional investors use stock options to manage their risk, limit their exposure to price fluctuation on a particular stock, while small-scale investors - often with little experience - mostly speculate on the future price of the stocks or index funds.
Types of options
Simply put, there are two types of options: call and put options. With call options, the investor speculates that the price of the stock (or any other underlying asset) will rise. In the put option, the investor anticipates that the underlying asset’s price will decline. You are "in the money" with the call options when the underlying stock rises above the strike price. In the case of a put option, you are "in the money" when the underlying stock price drops under the strike price.
American vs European
Bear in mind that there are two different styles of options. In the case of US options, you can exercise your right granted by the option agreement any time between the purchase and the expiration date. The less common European option can only be exercised on the expiration date. The bigger turnover in stock options happens on American markets.
If you start investing in stock options, you will come across letters in the Greek alphabet describing options positions. The so-called “Greeks” - a collective term of the delta, gamma, vega, and theta of traders' option positions - provide a way to measure the sensitivity of an option's price compared to various factors.
This can be complicated and you need time to practice and understand what each value is measuring. In short, delta shows us how the change in the price of the underlying asset is expected to change the price of the option. Gamma helps us understand the rate of change in delta over time. Theta measures how sensitive the option price is relative to time, it shows the time decay of the option’s value. And vega measures how sensitive the option price is relative to the volatility of the underlying stock.
How do stock options work in practice?
Sounds all a bit complex? Here is an example!
Say, you want to buy into a company. You could buy a share for $10 in a particular stock now. However, you don't have the necessary funds just yet, you are uncertain about where the stock price will move or want to speculate on the market price of the stock. So you purchase an option to buy a share at $10 for XY amount of money within a certain timeframe. Depending on how the price moves within that time frame compared to your $10 per share option, or strike price, you might be making or losing money.
The volume of stock options really took off in 2020 when individual investors piled into the market: it jumped by 68 percent compared to 2019, according to data compiled by CBOE Global Markets, a leading options exchange. A word of caution: options trading is risky and not recommended for beginners!
Options taking control - the example of Gamestop
A new trend seems to be emerging in the options market with retail investors increasingly trying their luck in options trading during the pandemic. With so many individual investors pouring into options trading the options market often drives the regular stock market.
If many traders buy call options at the same time on a stock, they can create a situation where prices start going up for that particular stock on the regular stock market. Individual investors are pushing the price up by betting that the price will go up - like a self-fulfilling prophecy. Brokerage firms buy a percentage of the stock they would need to sell if the buyer ended up making money on the bet. As stock prices rise, they need to buy more shares to keep their balance. Buying more shares keeps pushing up the stock price.
It is the classic case of the tail wagging the dog, when the options market drives the regular stock market as was the case with Gamestop in early 2021. Shares of the otherwise struggling video game retailer Gamestop surged when many small-scale investors decided to buy call options. The investors banded together when at least two hedge funds, seasoned institutional investors had bet that Gamestop’s shares would fall.
Since it requires less money to buy an option, investors can control a larger volume of the stock than they could if they bought the actual shares directly and this is what makes the options market so potent.
Where to start trading options?
You can get into options trading through online brokerages, with different tools designed to manage risk. We at BrokerChooser tested, compared and analysed more than 90 quality online brokers to give you this guide to the best options trading platforms. Check it out to get started!
Where to look for more?
Hope you liked this quick rundown on what options, and particularly options on stock, are. If you'd like to go deeper, navigate to one of the articles below: