Investing is an important way to build wealth and a secure financial future. But the stock market can also be confusing. Even if you already know basics like how to buy and hold stocks and exchange-traded funds, you may be confused by what else you can do besides actually buying and selling stocks.
Among the different investment techniques which confuse new investors are options. You may have heard of stock options being offered to employees or being bought and sold on the open market. But what exactly are options? How do they work, what types are there, and how can you use them to actually make money? Here’s what you need to know about stock options.
What are stock options?
As you probably already know, stocks represent shares of a company. They can be bought and sold. If you buy a stock, you hope that its value will go up so that you can sell it.
You can also “short-sell” a stock. Shorting a stock means promising to sell a stock you don’t yet own at an agreed-upon price. It’s something investors do in order to bet on a stock’s price dropping. If the price does indeed drop, then the investor can buy it cheap and sell it at the (higher) agreed-upon price.
But going short or long (buying the stock without short-selling it) in these ways exposes investors to significant risks. Options exist to present an alternative. Options are bought and sold as contracts. They stipulate an agreed-upon price and timeframe for a stock to be bought or sold. But, as the name implies, the contract offers one party the option to do these things. This enables less risky versions of the short and long moves we’re already familiar with.
If you want to go long on a stock, then you don’t have to buy it — you can buy the option to buy it at a low price. If the stock rises, you exercise the option and buy a pricey stock for less. You’ve spent a bit more, since you had to pay for the option, but your risks were lower. If the stock dropped instead of growing, you could simply decline your option and lose only what you paid for the options contract. You won’t have put a bunch of money into a sinking stock. The same is true for shorting with options, of course. If the stock rises instead of dropping, you can breathe a sigh of relief knowing that you don’t have to go buy pricey stock to sell at a loss. You can simply decline your option to sell that stock you don’t own.
Types of stock options
In the process of explaining stock options, we’ve touched on two types of stock options. One is the option to sell a stock, and the other is the option to buy a stock. These type of moves have names.
If you’ve purchased the right to buy a stock at a certain price, what you have purchased is called a “call” option. The other type of stock option is a “put” option. A put option is the option to sell a stock at a certain price. Sounds pretty straightforward, right? It’s easy to find more call and put options examples if you look around.
These options aren’t exactly reciprocal. Options contracts like these are one-way deals: someone has the right to make the decision on whether or not to exercise the option. In certain situations, investors can also sell options. If you’re the one who sells the option, you’re selling someone else the right to decide if they want to buy an investment from or sell an investment to you at a certain price within a certain time frame — the decision is with whoever holds the option.
Being smart with options
Options offer investors new ways to make money and new ways to limit risk. Using options wisely to mitigate riskier bets can give you the power to leverage smaller amounts of money into bigger gains. If you’re hoping to make the most of an options trading strategy, keep reading and learning. Work with financial advisors, take courses, and read guides to maximize your abilities and your profits.