How do stock options work?

Stock options work through a contractual agreement between two parties, the option holder (buyer) and the option writer (seller), in which the holder acquires the right to buy (in the case of a call option) or sell (in the case of a put option) a specific number of shares of a particular stock at a predetermined price (the strike price) within a specified time frame (until the expiration date). The process typically involves the following steps:

1. Issuing the Option Contract:

   • An investor or trader who believes that the price of a particular stock will move in a certain direction (up or down) can initiate the process by purchasing an option contract.
   • The option holder pays a premium to the option writer for the contract. The premium is the cost of buying the option.

2. Call Options:

   • If the investor believes the stock price will rise, they buy a call option. A call option gives the holder the right to buy the underlying stock at the strike price.

3. Put Options:

   • If the investor believes the stock price will fall, they buy a put option. A put option gives the holder the right to sell the underlying stock at the strike price.

4. Option Expiration:

   • Every option contract has an expiration date. This is the last day on which the option can be exercised. Option contracts are typically available with various expiration dates, ranging from days to several years.

5. Option Exercise:

   • If the option holder decides to exercise the option, they can do so by notifying their broker or through the trading platform. Exercising means acting on the right to buy or sell the underlying stock at the strike price.
   • For call options, exercising means buying the stock at the strike price.
   • For put options, exercising means selling the stock at the strike price.
   • It's important to note that not all options are exercised. Whether an option is exercised depends on factors such as the market price of the underlying stock and the holder's profit or loss.

6. Option Settlement:

   • After the option is exercised, the settlement process occurs. Settlement can be either physical or cash settlement, depending on the type of option and the brokerage account.
   • In physical settlement, the underlying stock is actually bought or sold at the strike price. The shares are transferred to or from the holder's account.
   • In cash settlement, the option's profit or loss is paid out in cash to the option holder.

7. Selling Options:

   • Option holders are not required to exercise their options. They can also sell their options to other investors in the secondary options market before the expiration date. This allows for potential profit or loss based on changes in the option's market value.

8. Option Writer's Obligations:

   • Option writers (sellers) have an obligation to fulfill the terms of the contract if the option holder decides to exercise the option. This means they must sell the stock (in the case of a call option) or buy the stock (in the case of a put option) at the agreed-upon strike price.
   • Option writers receive the premium from the option buyer but face potentially unlimited risk, especially with Uncovered call options (selling calls without owning the underlying stock) or Uncovered put options (selling puts without having the funds to buy the underlying stock if assigned).

It's important to understand that trading stock options can be complex and involves risks. Investors should carefully consider their investment goals, risk tolerance, and knowledge of options before engaging in options trading. The value of options can be highly influenced by factors such as the stock's price, market volatility, time to expiration, and interest rates. Additionally, not all investors may have access to options trading, as it often requires approval from brokerage firms due to the associated risks and complexities.