Trading options is complicated—and potentially high risk. With some options trades, you could stand to lose 100% of your investment, while others could expose you to unlimited losses. Whether you’re buying or selling calls or puts, it’s an advanced move—so there’s a lot to learn before jumping in.
The big picture
Options are a contract. You’re buying the right to either buy or sell a stock at a certain price for a specified period of time. Or, if you’re on the other side of the deal, you’re being paid for your promise to sell or buy the stock at a certain price for a specific period of time.
People buy or sell options depending on the direction they believe a stock price could move—up or down. There are two basic types of options: calls and puts.
Call and put options
You would typically buy a call option if you expect the price of the underlying stock to go up. Buying a call gives you the right to buy the stock at a specific price— known as the strike price—for a specified amount of time.
When you buy a put option, you generally think that the price of the underlying stock may go down. Buying a put gives you the right to sell the stock at the strike price for a certain amount of time.
Sellers versus buyers of calls and puts have the opposite hopes or expectations. Sellers of calls think the price of the stock will remain steady or could go down, while sellers of puts think the stock price will remain steady or could go up. Selling a call obligates you to sell the stock—while selling a put obligates you to buy the stock—at the strike price.
There’s another wrinkle on the selling side. You can choose to sell a call or a put on stocks you don’t actually own—in the lingo, that’s known as writing a naked call or a naked put. When you sell options on stocks you own, it’s called a covered call or a covered put.
What is the strike price?
For call options, the strike price is the price at which the underlying stock can be bought. For put options it’s the price at which the underlying shares can be sold.
If you buy a call, you would like the price of the stock to move above the strike price. If you wanted to, you could buy the stock at the strike price, and sell it for the higher price in the market. Or you could choose to not exercise the option and sell the call to another investor.
If you buy a put, you hope the price of the underlying stock will fall below the strike price—then you get to sell your shares at the strike price—a higher price than you could get in the market.
Why would you want to trade options?
People buy and sell options for a variety of reasons, ranging from hedging or protection to risky speculation.
Selling calls and puts provides income. You sell, or write, the call or put and pocket the premium. The premium is the price of the option contract paid by the buyer. It could be a risky way to make money, however, as buyers could choose to exercise the option if the stock price moves in their favor.
If you’re looking for a specific price to buy a stock, buying calls or selling puts lets you target that specific price.
If you’d like to sell a stock at a specific price, selling calls or buying puts allows you to target that price.
Options can also let you hedge your investments: for instance, using a strategy called a protective put. When you own a stock but are unwilling to risk much of a loss, you can buy a put with a strike price that suits you. If the price of the stock falls below the strike price, you sell the stock at the higher strike price.
In the money?
An important concept in options trading is known as “moneyness.” Your strike price can be “in the money,” “at the money,” or “out of the money.” In-the-money options contracts are worth money right now—you might want to exercise the option and go ahead and buy or sell the stock, or sell the contract to someone else. In-the-money options contracts are more expensive than at-the-money or out-of-the-money options contracts.
A call option is in the money when the underlying stock price is above the strike price. You could, for instance, exercise the option in order to purchase the stock at the strike price, and then sell the stock at the higher price in the market.
A put option is in the money when the underlying stock price is below the strike price. If you buy an in-the-money put, you have the right to sell the stock at a higher price than you could get in the market.
But, again, you don’t have to exercise the option—you could sell it to another investor.
How much do options cost?
An option buyer must pay the seller a premium. The actual price of an options contract will depend on several factors including: the stock price, the strike price, and the length of time until the option expires.
In-the-money options are relatively more expensive than out-of-the money options. But there is also value in time. If everything else is equal, an option with a longer time until it expires will be worth more than one expiring soon. With more time, there’s a higher likelihood that the option will be in the money before it expires.
Options in action
The investment world has its own language. Here’s how options are written and how to read them.
After deciding to buy or sell a call or a put, you have to decide on a strike price that makes the most sense for your plan. Read the story “Hitting the right strike price” on Fidelity.com to get some tips on picking the right strike price for your options strategy.
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