Options can be confusing, complex, and risky. Still, they’re popular among investors who understand their mechanics. Why? Because options can produce gains and income. They’re also widely used to protect against losses in a portfolio.
What are stock options?
Stock options are legal contracts that grant the right to buy or sell a security, like a stock or ETF, at a specific price before a certain date. The contract specifies:
Whether the contract allows shares to be bought or sold
How many shares can be transacted under the agreement
The price at which the shares can be transacted, called the strike price or exercise price
The expiration date when the contract expires with no value
Whether the option is American or European, which affects exercise timing (American options can be exercised anytime before expiration, and European options can only be exercised at expiration)
There are two parties to an options contract: a buyer and a seller. The buyer, known as the option holder, purchases the contract by paying a nonrefundable premium to the seller, who is called the option writer. The rights and obligations of option holders and writers differ based on the type of contract. The two main types are calls and puts.
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Call and put options defined
Holders don’t have to exercise their options. For example, the holder of a call option wouldn’t proceed with the transaction if the market price of the stock is less than the strike price. In that case, the better strategy is to do nothing and let the option expire. Alternatively, the holder can sell the option to a third party before expiration.
Option writers have fewer choices. If the holder exercises the option, the writer must fulfill the transaction.
Note that writers can sell covered or uncovered positions. Covered options are backed by owned shares or cash collateral, depending on the contract type. Uncovered, or naked,…
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