Options can provide a way to leverage your investments or hedge against risk. With these financial instruments, you can gain exposure to stocks and have more versatility with trading strategies than you would with direct buying and selling.
Options trading is generally more complex than trading other securities like stocks and bonds. Investors can benefit from using options if they understand how they work and how they trade, as well as about their risks.
What Is an Option?
An option, also called a derivative, is a contract that gives you the right, but not the obligation, to buy or sell an underlying asset at a certain price before a specific date. Underlying assets may include stocks, exchange-traded funds (ETFs), stock indices, foreign currencies, fixed-income products, and more.1
Options have expiration dates, after which your right to buy or sell the underlying asset expires. Before then, you can purchase or sell the asset at any time. After the expiration date, the option no longer exists.
When you hold an option, you do not actually own the asset itself like you do when you buy shares of a stock. Instead, you own the ability to buy or sell it for a certain price before a specific date.
Calls vs. Puts
Two of the most common types of options contracts are call options and put options. Which one you use will depend on how you expect the underlying asset to perform.2
- Calls: Call options give the owner the right to buy the underlying asset at a certain price up until a specific date. Investors can profit with call options if the price of the underlying asset increases.
- Puts: Put options give the owner the right to sell the underlying asset at a certain price up until a specific date. Investors can profit from put options if the price of the underlying asset declines.
How Options Trading Works
Options can provide more investment strategies for different market conditions compared to directly buying and selling an asset. You can use options to potentially profit from price changes in stocks or other assets without owning them. You can also use options to generate income or to hedge against risk.
The price at which you can buy or sell the underlying asset is called the strike price. The strike price’s relationship to the actual price of the asset determines whether the option is in-the-money, out-of-the money or at-the-money.
- In-the-money: A call option is in-the-money when the price of the underlying asset is higher than the strike price. A put option is in-the-money when the asset price is lower than the strike price.
- Out-of-the-money: A call option is out-of-the-money when the price of the underlying asset is lower than the strike price. A put option is out-of-the-money when the asset price is higher than the strike price.
- At-the-money: A call or put option is at-the-money when the asset price and strike price are the same.
Example of an Option
To illustrate how options work, suppose a stock is trading at $50 per share. You purchase a call option giving you the right to buy the stock within three months at a price of $53 per share and the contract costs $2. To profit from this option, you would need share prices to rise to more than $55.
If shares climbed to $58 before the expiration date, you could exercise the option and earn a profit of $5 for one share. However, if shares remain below that amount and you do not exercise your option, you would lose your $2 premium.
Keep in mind that this is a basic example of how options work. Investors generally buy contracts at higher volumes, and they may face other fees.
How to Invest in Options
To trade options, you’ll need a brokerage account that permits options trading. Each brokerage firm will have its own standards for which options you may trade, and you’ll usually need specific approval. You can make options trades for a single contract or for several contracts.
The strategy you use to invest in options will depend on factors like your risk tolerance and investing objectives, as well as how you believe the market will perform. For example, if you want to hedge against risk, you may want to buy a put on a stock position you have. Then, if the price declines significantly, you can minimize losses from your original position and potentially profit by exercising the option.
Pros and Cons of Investing in Options
Options can offer investors several opportunities to earn profits. They provide versatility as you can lock in the price of a stock or asset without the commitment of buying it. If the underlying asset performs in your favor, you could earn more income from exercising your option or minimize losses through hedging.
However, like other securities, options have no guarantees for how they will perform. You could lose money, including losing your premium if you don’t exercise the option. Options are also more complex than buying and selling stocks or other assets directly.3
The Bottom Line
Options are more advanced tools for investing compared to assets like stocks or bonds. With proper planning, you can take advantage of these products to potentially increase income and hedge against risk. However, make sure you fully understand the risks before investing in any asset.
If you want to include options in your portfolio, consider consulting a financial professional for guidance on how they may fit into your specific investing strategy.
Options are not suitable for all investors. Investors cannot invest directly in indices.
1 FINRA, “Investment Products: Options” https://www.finra.org/investors/investing/investment-products/options
2 Investor.gov, “Investor Bulletin: An Introduction to Options” https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-63
3 U.S. Securities and Exchange Commission, “Investor Bulletin: An Introduction to Options” https://www.sec.gov/oiea/investor-alerts-bulletins/ib_introductionoptions
