Stock options have been fascinating traders ever since they burst onto the investing scene in 1973. The advantages of stock options are undeniable, and as more and more investors have caught wind of these benefits, the options market has exploded in popularity.
In 2014, the total volume of stock option contracts traded surpassed 4.3 billion contracts, according to the Options Clearing Corporation.
So what’s all the fuss about? What are stock options and how can you use them to score big profits on Wall Street?
Before highlighting a few of their powerful advantages let’s first explore how exactly a stock option works.
Getting to Know Stock Options
For starters, options are contracts. In the stock market, you buy shares of a company in hopes that they will appreciate in value, or at least pay you a respectable dividend while you wait. Options, on the other hand, are bought and sold as contracts, not shares.
The contracts come in one of two flavors: calls and puts.
The official specifications of options can seem a bit wonky, but it’s worth reading to get an idea of what we’re dealing with here.
- A call option is a contract that gives the buyer the right, but not the obligation, to buy 100 shares of stock at a specific price on or before the expiration date.
- A put option is a contract that gives the buyer the right, but not the obligation, to sell 100 shares of stock at a specific price on or before the expiration date.
Confused? Don’t be. Just think of a call option as a coupon that locks in the right to buy a stock at a set price. And just like a coupon, it has an expiration date. Since the call option locks in the right to buy stock, it rises in value as the stock rises in value. Buying call options, then, is a popular alternative to buying shares of stock you believe will rally higher over time.
Put options are the bearish counterpart to calls. Since they lock in the right to sell a stock at a set price, they rise in value as the stock declines. Possessing the right to sell a stock at $100 becomes more valuable if the stock ends up tumbling to $90, $80 and below. Buying puts, then, is a popular alternative to shorting shares of stock.
The beauty of the stock option route has to do with the twin advantages of leverage and limited liability. Because calls and puts are so cheap, they don’t require you to tie-up near as much capital as a stock purchase would. As a result, your liability, or risk, is drastically less than a stock position.
“Leverage” is the sexy term that we traders like to use for the ability to generate big profits. Due to the inherent leverage in stock options, a small move in the stock can result in a massive move in the option. For example, a 5% rise in Apple Inc. (NASDAQ:AAPL) stock may generate a 50% increase in the value of AAPL call options. Or, alternatively, a 5% drop in AAPL may deliver a 50% gain in the value of AAPL put options.
Due to the potential for amped-up returns, speculators have flocked to the options market in droves. But don’t think it’s only the domain of the swashbuckler. Conservative investors also can use options as a risk reducer. But that, my friends, is a story for another day.
The bottom line: Stock options offer limited liability, leverage and a host of other advantages that demand a closer look for investors of all stripes.
