What Are Stock Options?
Stock options are contracts that give investors the right (but not obligation) to buy or sell a stock at a certain price, before a certain date. Simply put, it’s a method of trading stocks on leverage.
For example, when you buy a call option, you buy the contract that will allow you to buy 100 shares of a stock at a fixed price (called strike price). But, this contract is not valid indefinitely, it comes with an expiration date. The expiration date and the strike price play a crucial role in determining in the price (premium) of the contract.
Similarly, when you buy a put option, you buy the contract that will allow you to sell 100 shares of a stock at a fixed price (called strike price). Put options also come with an expiration date.
Basic Terminology In The World of Options
Premium:
The amount paid for purchasing a call or put option contract.
Strike Price:
The share price at which the call option contract allows you to buy the shares. In case of put options, the strike price is the share price at which you can sell your shares.
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Expiration:
The last day on which the call or put option can be exercised. It is the end of the validity of the contract.
Exercise:
The act of using the call option to actually buy the 100 shares at the given strike price. Similarly, it is the act of using the put option to actually sell 100 shares at the given strike price.
Intrinsic Value:
The price difference between the share price and the strike price of the option.
- For call option, when the share price is higher than strike value, intrinsic value = share price – strike price.
- For put option, when the share price is lower than strike price, intrinsic value = strike price – share price.
Delta:
Delta is the relative price movement in the price of the ‘option’ compared to the movement in stock price. For example, when the stock price moves up by $10, and the ‘premium’ rises by $7, delta = 70%.
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Stock Options vs Stock
There are two main differences between stocks and stock options.
- You can buy individual shares like 1,2,3 shares or even fractional shares. But, when buying call or put options, you buy contracts on a lot of 100 shares typically.
- When you buy a stock, it does not have any expiration date. However, a stock option (call or put), it comes with an expiration date.
How do Stock Options Work?
If you believe a stock price will go up, you can buy call options to gain from the upside, by investing a fraction of the cost of the stock (100 shares per contract). Call options are a way to leverage your ‘long’ bets. Click for details on Call options with examples.
If you believe the stock price will go down, you can buy put option to gain from the downside, by investing a fraction of the cost of the stock (100 shares per contract). Put options, like call options are a way to leverage your ‘short’ bets. However, unlike call options where the potential gain is unlimited, put options get capped at the value of the strike price (x 100). Click for details on Put Options with examples.
In The Money vs Out of Money Call Options
When the share price (e.g. $325) is above the strike price (e.g. $300) of the call option contract, the call is considered in the money. That’s because the option is theoretically worth some money (intrinsic value), in this case $325 – $300 = 25 per share. On the flip side, when the share price (e.g. $295) is below the strike price (e.g. $300) of the call option contract, the option is considered out of money. That’s because theoretically the call option is worthless (no intrinsic value).
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In The Money vs Out of Money Put Options
When the share price (e.g. $325) is below the strike price (e.g. $350) of the put option contract, the put is considered in the money. When the share price is above the strike price of the put option contract, the put option is considered out of money.
How are Stock Options Taxed?
There are two ways taxes are considered when trading options – one for individual stock options, one for options on index funds (such as S&P500 index fund). Gains in trading individual stock options are treated as ordinary income and taxed using the ‘short term tax rate’. Gains in trading options on index funds are treated differently – 60% is taxed at ‘long-term tax rate’ and remaining 40% is taxed at ‘short-term tax rate’.
We are NOT tax advisors, please consult a tax advisor for most updated tax laws in your region
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