What Are Stock Options and How Do They Work?

by Stacy Francis, CFP®, CDFA

This question popped up during a recent Savvy Ladies meeting. This Savvy Lady saw an advertisement on the internet for a course called Stock Options for the Savvy Trader – Make Millions With Little To No Risk. Should she sign up? It seemed like it might be to good to be true. Well, your right. This class is not all it says it is. While frequently referred to among investors, few truly grasp what stock options are. I will provide the basics below.

As the owner of a stock option, you have the option (but not the obligation) to either buy or sell a certain stock at a certain price. A call option gives you the right to buy a stock at a certain price, whereas a put option grants you the right to sell a stock at a certain price. Hence, call options can be great buys when you expect a stock to go up, while put options can be great buys when you expect it to go down.

How? Well . . . if you bought an option a while back, to buy a certain stock for $50, and that stock now trades at $60, you can exercise the option and buy the stock for $50, turn around and sell it for $60, and walk away with a profit of $10 minus what you paid for the option.

If, on the other hand, you bought a put option a while back, to sell a certain stock for $50, and the stock now trades at $40, you can buy stock in the market for $40, exercise your option and sell it for $50, and – again – make $10 minus what you paid for the option.

The worst thing that can happen when you own options is that they become worthless and you lose whatever money you put into them. This will happen for call options when the price of the stock goes down, and for put options when the price of the stock goes up.

Sophisticated investors sometimes create extra income for themselves by writing and selling options on the stocks they own. But that is a whole other chapter that we will save for later.