stock analysis

Stock Options Explained – Know the Basics

Now is more of an exciting time than ever to think about investing in the stock market if you haven’t thought about it before.

The impact of COVID-19 has drastically impacted the stock market, opening up new doors of opportunity that did not exist previously. A thriving economy helped increase stock prices while the aftermath of COVID-19 drew many companies to their 52 week low.

With many valuable companies trading at extremely low prices, now is the time to do your research, understand more about the stock market, and make yourself another stream of income. Developing your own stock option trading strategy can extremely profitable and can minimize your losses.

In such a volatile market, I chose to focus specifically on options and continue to share what I learn on BeginnerStockoptions.com. It is my goal to share as I learn myself as the best way to really “get” something is to share, teach, and discuss it with others. Stock options explained right here for you, the reader.

stock option basics

What is a Stock Option?

A stock option is the right granted to an investor, not an obligation, to buy or sell a stock at a specifically agreed upon price and date. Stock options are traded on exchanges similar to the stocks themselves. The price of an option can be lower or higher than the current market price of the stock and options. Call and put options are placed on whether a trader believes a company’s stock market price will go up or down.

Stock option investors have 3 options prior to their stock option expiration date:

  1. Exercise the option: buying or selling the number of shares associated with the option.
  2. Selling the option
  3. Letting the option expire

Components of a Stock Option

The strike price is the price an investor expects a stock to increase above or below by a specific date. Strike prices determine whether an option should be exercised. For example, a stock trader might believe a company such as JNJ or Johnson & Johnson will go up in the future and place a call option for a specific month and a particular strike price.

Each option has a specific date that it expires, simply called the expiration date. Most conform to a calendar and typically expire the third Friday of each month in which the stock was written. Some companies only have options available with monthly expiration dates while others have weekly expiration dates. It is important to help traders price the value of the put and the call.

The number of options a trader is looking to buy are called contracts. Each single contract that is bought holds 100 shares of the underlying company stock. If you bought 3 contracts of JNJ, that would be 300 shares of underlying stock.

Premiums are the amounts of money paid from the buyer to the seller for the option contract. For example, let’s say you buy 5 May JNJ call option contracts at a strike price of $170 at a cost of $0.91. Each 1 option contract contains 100 shares and the price for the premium is represented for 1 share. You would owe the seller of the JNJ calls a $455 premium (5 X 0.91 X 100).

Premium = (cost of option) X # of Contracts X 100

Strike and Premium Prices
Where to Find Strike and Premium Prices Example

Call Options – Bet that a Stock Price will Increase

Call options allow the buyer to buy shares of stock at a set price within a set time period. People consider buying calling options when they anticipate that a particular market stock price will increase in the future. Say a company is about to release a new product, release positive earning and growth reports, or any other positive news that may increase the value and sales of a company, buying a call could potentially make you some money.

Now let’s say that we have a stock trader, Anne. She thinks that Walt Disney stock is going to increase in the future to over $120 per share, up from the current market price of $100. Anne decides to buy 10 May 29th $120 Calls which trade at a price of $0.17 per contract. This would result in Anne spending $170 to purchase the calls.

For Anne to earn a profit, the stock would need to rise above the strike price and the cost of calls, or $120.17. If the stock does not rise above $120, the option is worthless and expires; Anne would lose her entire $170 premium.

Put Options – Bet that a Stock Price will Drop

Put options allow the buyer to sell shares of a stock at a set price within a set time period.

Our trader Anne thinks the company stock for the Walt Disney (NYSE: DIS) is going to drop. Say DIS is currently trading at a market price for $100 per share. Anne decides to buy 10 May 29th $85 Puts for DIS for $0.65 per contract. It would cost Anne a total of $650. For Anne to earn a profit, the stock would need to drop below $84.35. If the stock closes above $85, the options would expire worthless, Anne would lose her $650 premium.

You are On Your Way

The stock market and stock options can seem intimidating at first, however I believe anyone can learn how to do it. Be sure to allow yourself the time and patience to learn it. It is important to learn the basics and develop a trading strategy based on facts and understanding.

Now that you know what is a stock option is, the difference between a put and a call option, and the basic components of a stock option, you have begun the path towards creating a better financial future for yourself. Now is the time to learn how to join the lucrative game of stock option trading.

Practice: Look up a stock, find its options, choose an expiration date, choose a strike price for a call and a strike price for a put, and try to determine what the total cost would be to buy a contract.

12 Replies to “Stock Options Explained – Know the Basics”

  1. Hi Sonia,

    I usually avoid articles about stock markets, because I have trouble understanding most of it, but I was interested in reading your blog post, because I would like to invest in a stock, despite my lack of knowledge about it. You explained everything very well and made it quite clear to me. This is the best article I have read about buying stocks so far, you finally made it clear 🙂 but it still seems an intimidating prospect to me 😉 When the expiration date expires, what happens to your stock?
    What stocks are good to invest in now during COVID?

    1. In reference to selling a covered call option and then that stock option contract date expires, a few things can happen:

      1) If the stock share market price did not increase to the strike price before the expiration date [target price for which the option was wrote give the premium price you were paid ($55+2.50 = 57.50)], the premium expires and you keep the $250 paid to you by the buyer of that option contract with no further obligations.

      2) If the stock share market price goes up to $57.50 or higher during the term of the contract, the buyer of the contract can turn in their right to make you sell the 100 shares you owned for $55 each.

      3) As for good stocks to invest in now during COVID-19, it would depend what your investment goals are: long-term/short-term gains, conservative/non-conservative approach, ect.

      I would start listening to some finances news. There’s no guarantees, especially with the market volatility with COVID-19.

      I really enjoy Jim Cramer who has a show on CNBC called “Mad Money”. I would listen to a few of his shows this week, and you can learn some of the short-term and long-term predicted trends that are going on right now. And no, I am not getting paid to promote him…at least not yet :P. There’s other good shows out there too, but he’s my personal favorite and has a COVID-19 index list of stocks.

      Most people start with mutual funds and/or ETFs as they automatically provide you with a diverse portfolio of stocks, and one of the biggest mistakes I have heard when getting started is putting all of your eggs in one basket.

      For individual stock investing, stocks with dividends are typically more stable market price wise than those that do not as many investors don’t want to sell their stock and lose out on their dividends.

  2. This definitely is the time to start thinking about investing and I’m monitoring the stock and mutual funds markets very closely. Will definitely be looking at stock options too going forward – thank you!

  3. Hello, Sonia
    Your article is interesting, I was always thinking about getting into stock market. I never had anyone to teach me or help me. I know that you will be able to explain everything to me.

  4. Interesting not my area of expertise so so this is a very interesting introduction and very helpful as a step by step guide ..thanks for sharing, Phil

  5. Hi,

    I’ve never looked into this option of stocks before despite having the money dream. I am so grateful to come across this information on your website.

    Many Thanks for educating so many people out there looking for options to make money.

    Best wishes
    Rani

  6. In the Call options scenario, how much would Anne have made had the stock risen above the strike price?
    In the PUT options scenario, how much would she have made had the stock gone below $84.35?

    I am a self taught stock trader as of the past 18 months or so. I am happy to report I knew enough to get in and take advantage of some of the sales this past couple months. From the lips of Warren Buffet “simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
    Best advise ever.

  7. Hi Teresa,
    In the Call scenario, how much money she makes if the stock goes above the strike price depends on when she chooses to close the call option, how high the market price jumps, and the time frame of the expiration date.

    She can close out the call option at any time she wishes. Say she listens to analysts that set the expected price to jump to $200 within that time frame. She could exit when it gets to $125, $150, etc. since if she thinks the analysts are overshooting, or she could wait and see if jumps that high.

    The longer the time frame she waits to take her money, the higher the risk but possibly the higher the reward. I like what you said about Buffett’s advice because that is very true.

    With a Covered PUT option: If the market price went to $60 at expiration, she would have the right to sell 1000 (10 contracts = 1000 underlying shares) shares for $85. She would not make any money, but she would greatly reduce the loss she would have taken with the 1000 shares had she not purchased the put option.

    With an uncovered put option: She could buy 1000 shares for $60, then turn around and sell them using her put option contract for $85, making a profit of $25 minus the cost of premium per contract or 100 shares.

    Hope that helps,
    Sonia

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