Now that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's Tequila Company.
Let's say that on May1st, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July70 Call, which indicates that the expiration is the 3rd Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example.
Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.
When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.
Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits–unless, of course, you think the stock price will continue to rise.... Say we let it ride.
By the expiration date, the price tanks and is now $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315.
To recap, here is what happened to our option investment:
| Date | May1st | May21st | Expiry Date |
|---|
| Stock Price | $67 | $78 | $62 |
| Call Price | $3.15 | $8.25 | worthless |
| Contract Value | $315 | $825 | $0 |
| Paper Gain/Loss | $0 | $510 | -$315 |
The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action.
Exercising Versus Selling
So far we've talked about options as the right to buy or sell the underlying. This is true, but in actuality a majority of options are not actually exercised.
In our example you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value.
However, the majority of the time holders choose to take their profits by selling (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE about 10% of options are exercised, 60% are closed out, and 30% expire worthless.
Intrinsic Value and Time Value
At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value.
Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, is the amount that the price of the stock is higher than the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following:
| Premium = | Intrinsic Value | + | Time Value |
|---|
| $8.25 = | $8 | + | $0.25 |
Premium ($8,25) = Intrinsic Value ($8) + Time Value ($0,25)
In real life options almost always trade above intrinsic value.
FAQs
Example: Stock X is trading for $20 per share, and a call with a strike price of $20 and expiration in four months is trading at $1. The contract pays a premium of $100, or one contract * $1 * 100 shares represented per contract. The trader buys 100 shares of stock for $2,000 and sells one call to receive $100.
What is an example of how put options work? ›
Example of a put option
If the ABC company's stock drops to $80, you could exercise the option and sell 100 shares at $100 per share, resulting in a total profit of $1,500. Broken out is the $20 profit minus the $5 premium paid for the option, multiplied by 100 shares.
How do options actually work? ›
An option is a contract giving the buyer the right—but not the obligation—to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date. People use options for income, to speculate, and to hedge risk.
What is an example of an options contract? ›
For example, suppose you purchase a call option for stock at a strike price of Rs 200 and the expiration date is in two months. If within that period, the stock price rises to Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to make a profit of Rs 240-200 = Rs 40.
How do options work in an example? ›
Options contracts usually represent 100 shares of the underlying security. The buyer pays a premium fee for each contract.1 For example, if an option has a premium of 35 cents per contract, buying one option costs $35 ($0.35 x 100 = $35).
What is a real life example of a call option? ›
You buy a call option with strike price of 16500 at a premium of Rs. 115 with expiry date Jan 27, 2022. A Call option gives the buyer the right, but not the obligation to buy the underlying at the strike price. So in this example, you have the right to buy Nifty at 16460.
What are options in simple words? ›
An option is a derivative, a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset by a certain date (expiration date) at a specified price (strike price).
What is an example of an option profit? ›
Example 1. Imagine Apple is trading at $110 at expiry, the strike price for the option contract (consisting of 100 shares) is $100, and the options cost the buyer $2 per share; the profit is $110 - ($100 + $2) = $8.
What is an example of selling a call option? ›
Example of Selling Call Options
For instance, there is a stock ABC trading at 1,000 per share. You could sell a call on that stock with a 1,000 strike price for 200 with expiration in eight months. One contract would give you 20,000 (this is 200*1 contract*100 shares).
What is an example of an options call? ›
For instance, 1 ABC 110 call option gives the owner the right to buy 100 ABC Inc. shares for $110 each (that's the strike price), regardless of the market price of ABC shares, until the option's expiration date.
Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options' variables. Call options, simply known as Calls, give the buyer a right to buy a particular stock at that option's strike price.
How to do options trading? ›
You can get started trading options by opening an account, choosing to buy or sell puts or calls, and choosing an appropriate strike price and timeframe. Generally speaking, call buyers and put sellers profit when the underlying stock rises in value. Put buyers and call sellers profit when it falls.
How options are working? ›
Options trading is a type of financial trading that allows investors to buy or sell the right to purchase or sell an underlying asset at a fixed price, at a future date. Options trading operates on the basis that the buyer has the option to exercise the contract but is not under any obligation to do so.
How do options make money? ›
Basics of Option Profitability
A call option buyer stands to profit if the underlying asset, say a stock, rises above the strike price before expiry. A put option buyer makes a profit if the price falls below the strike price before the expiration.
Should I trade options as a beginner? ›
If you're looking to get started, you could start trading options with just a few hundred dollars. However, if you make a wrong bet, you could lose your whole investment in weeks or months. A safer strategy is to become a long-term buy-and-hold investor and grow your wealth over time.
What is a put option practical example? ›
On Jan 1, 2022, Nifty is at 16460. You buy a put option with strike price of 16500 at a premium of Rs 160 with expiry date Jan 27, 2022. A put option gives the buyer of the option the right, but not the obligation, to sell the underlying at the strike price. In this example, you can sell Nifty at 16500.
What is an example of a put option clause? ›
(a) The Company hereby grants to each Investor an option (the “Put Option”) to sell to the Company on one occasion, and the Company is obligated to purchase from each Investor upon exercise of each such option, all of such Investor's Put Shares in accordance with the terms of this Article IV.
What is an example of an at the money put option? ›
Example of at the money
If the trader decides to buy a put option with a strike price of $12 instead, it would still be considered at the money if the market price was $12. However, it would only be in the money if the underlying asset's price fell beyond this point, but if the market rose it would be out of the money.
What is the strategy of a put option? ›
A protective put position is created by buying (or owning) stock and buying put options on a share-for-share basis. In the example, 100 shares are purchased (or owned) and one put is purchased. If the stock price declines, the purchased put provides protection below the strike price.
