Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Key Points
• Buying a call option gives an investor the right, but not the obligation, to buy shares of an underlying asset at a specific price and by a specific date, to potentially profit from a price increase.
• Buying a put option gives an investor the right, but not the obligation, to sell shares of an underlying asset at a specific price and by a specific date, to potentially profit from a price decrease.
• The buyer of a call or put option must pay the seller a premium for the options contract, assessed per share.
• The price at which an option can be exercised, as specified in the option contract, is called the strike price.
• Options trading involves risks, including potentially substantial losses.
While most investors are familiar with buying and selling shares of stock directly, investing in options is another way to put money behind stock price movements.
Options are a type of derivative contract that allows the investor to buy (or sell) a stock, or some other asset, at a certain price within a specific time period. The two basic types of options are known as “puts” and “calls.”
Options trading is a popular strategy for day traders, because it offers the potential to make profits within a shorter time frame, as opposed to owning shares of stock outright, and waiting for the price to move in the desired direction. Options trading can potentially generate returns, but it can also amplify losses, making it a risky strategy.
Overview: What Are Options?
In options trading, an option contract is a derivative instrument that’s based on an underlying asset: e.g., stocks, bonds, commodities, or other securities. Thus, the buyer of an options contract doesn’t purchase the asset directly, but a contract with an option to buy or sell that security. For example, with stocks, also called equity options, one contract represents 100 shares.
Options come in two flavors, as noted above: calls and puts. For the sake of simplicity, this article will refer primarily to stock or equity options.
Options Buyers vs. Options Sellers
An options buyer, also called the holder, has the right, but not the obligation, to buy or sell the underlying asset at the agreed-upon price (the strike price) by a specific date (the expiration). Buyers pay a premium for each option contract, which is assessed per share. If there is a $1 premium per share, at 100 shares, the total cost of the option is $100.
The potential upside for an options buyer could be unlimited, depending on their strategy. And since an options buyer is not obligated to exercise their option — meaning to actually buy or sell the underlying stock at the price agreed to in the option contract — the most they stand to lose is the premium paid for the option.
An options seller, also called the options writer, is on the other side of the trade. In this case, if the options holder exercises the contract, the option seller has an obligation to buy or sell the underlying asset at the strike price.
The potential upside for an options seller is the option’s premium. Their potential downside depends on whether they’re selling a put option or a call option. More on this below.
Trading options requires familiarity with options terminology, since these strategies can be complex and come with the potential risk of steep losses, depending on the strategy.
💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
What Is a Call Option?
When purchased, a call option gives the options buyer the right, but not the obligation, to buy 100 shares of the underlying asset at the strike price, by the expiration of the contract.
Buying a call option can be appealing because it gives a buyer a way of profiting from a stock’s increase in price without having to pay what could be the current market price for 100 shares.
If the price of the underlying asset rises above the strike price, then the buyer may choose to exercise their option, paying less than what it’s worth on the market and potentially selling shares for a profit.
For a call option buyer, the profit is determined by the premium they pay and if, and by how much, the price of the security rises above the option’s strike price before it expires. The maximum potential upside is unlimited since, theoretically, the price of the underlying asset could continue to rise. The maximum potential downside is limited to the premium paid for the option.
Conversely, the seller, or writer, of the call option has the obligation to sell the underlying shares to the buyer, if the buyer exercises the option. The seller’s maximum potential gain is limited to the option’s premium. Their potential downside is unlimited, since they must sell shares at the option’s lower strike price, no matter how high the market price has risen.
Example of Buying a Call Option
If an investor buys an option with a strike price of $50 for a stock that’s currently worth $40, the option will be “out-of-the-money” until the stock rises to $50. If the premium is $1/share — meaning they only pay $1 up front — then the investor will only be risking $100, not $4,000.
If the stock is trading at $55 on or before the expiration date, it would make sense to “exercise” the option and buy the stock for $50, thus giving the investor shares with built-in profit thanks to the difference between the strike price of $50 and the value of $55. In this case the profit would be $4/ per share (or $400), minus the premium paid: a strike price of $50 gives the investor the right to buy 100 shares of a stock worth $55, with a premium of $1 per share.
On the other hand, if the stock has not risen enough in price, the investor can just let the option expire, having only lost the price of the premium, rather than being saddled with shares they can’t profit from.
Recommended: A Beginner’s Guide to Options Trading
What Is a Put Option?
A put option gives the investor buying the contract the right, but not the obligation, to sell the underlying security at the agreed-upon strike price, by the expiration date of the option.
If buying call options are a way to profit when the price of a stock or other underlying asset moves in the right direction, buying put options can be a way to profit from the fall of a stock’s price, without having to short the stock (i.e. borrow the shares and then buy them back at a lower price).
Purchasing a put option contract gives its buyer the right, but not the obligation, to sell shares at a certain price, at or by a specified time in the future. The key difference between buying a put vs. a call option is that the put option becomes increasingly valuable as the price of the underlying asset decreases. A put option buyer is hoping they can sell the underlying asset at a strike price that’s higher than the market price.
For the put option buyer, the maximum potential upside is the difference between the option’s higher strike price and the price at which the option is exercised (minus the premium), while the maximum potential downside is limited to the premium paid.
Again, the put option seller is on the other side of the trade, and is obligated to buy the shares from the put buyer, if the buyer decides to exercise the put option. The put option seller’s maximum upside is the option’s premium. Their potential downside extends to the difference between the option’s higher strike price and the lower market price at the time the option is exercised.
Example of Buying a Put Option
As an example, let’s say a stock is worth $50 today. If an investor thought the stock’s value could go down, they might buy a put option with a strike price of $40. Let’s say the premium for the option is $1, and they buy a contract that gives them the right to sell 100 shares at $40. The premium, then, is $100.
At the time the investor buys the put option, it’s out-of-the-money. If the price remains above $40 until it expires, the investor will not be able to exercise the option and they will lose the premium.
But if the stock has dropped from, say, $50 to $35, the option is in-the-money and if they were to exercise the option, they’d profit from being able to sell shares for $40 that are worth $35, pocketing $5 per share or $500, minus the $100 premium, leaving them with $400, minus any brokerage fees.
Risks of Options Trading
Option trading can be a useful way to manage risks in a volatile market and potentially profit from movements in stocks one doesn’t own. Again, an investor buying options only stands to lose the premium they pay for an options contract, though the cost of premiums can accrue if purchasing multiple options contracts over time.
However, an investor selling call options or put options, who is obligated to either buy or sell an option’s underlying assets per the terms of the options contract, could potentially see substantial losses. This is especially true if they don’t understand the potential downside to the trades they’re executing.
The Takeaway
Option trades may appeal to individual investors because they offer a way to potentially see a gain from movements in a stock price, without having to own the underlying shares. If an investor isn’t able to exercise the call or put option they purchased, they’ll lose the premium they paid for that contract. However, selling a call or put option can be high risk, potentially leading to significant losses.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button. Currently, investors can not sell options on SoFi Invest®.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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