Stock Options Investing Guide: What Are Stock Options and How Do They Work?

Trading stock options is one of the most potentially profitable ways to invest in the stock market and also one of the riskiest strategies that could wipe out an entire portfolio in a very short amount of time.

Buying and selling stock options is not a beginner’s investing strategy. However, it is one that experienced investors can gradually add to an overall investment portfolio over time. As an investor gains experience in the stock market and is looking to add some additional risk to their portfolio, stock options may be a viable tool worth understanding. If you are new to the stock market, start with our guide on how to invest in stocks before exploring options trading.

So what exactly are stock options, and how are they different from traditional investments?

What Is a Stock Option?

A stock option is a contract that gives the buyer the right, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain period or on a specific date.

There are four key concepts that define how stock options work:

• The right, but not the obligation

• To buy (call) or sell (put) a stock

• At an agreed-upon price (the strike price)

• Within a certain period or on a specific date (the expiration date)

Each of these concepts uniquely defines how a stock option functions, and they are explained in detail below.

How Stock Options Work: The Right But No Obligation

Very few investments give the buyer the right to purchase an asset without any obligation to follow through. When an investor purchases a stock, they immediately own that asset until they decide to sell. There is an obligation to own the stock once the trade is placed and filled.

Buying a call option, by contrast, gives the investor the right, but not the obligation, to purchase a stock at a predetermined price at a later date. In return for this right, the buyer pays a premium to the seller of the option.

Here is an example of how buying a call option works:

Say you are interested in purchasing 100 shares of a hypothetical company called ABC, which is currently trading at $50 per share. Buying 100 shares would require $5,000, but you are not sure you want to commit that much capital to a single investment.

An alternative is to purchase one call option contract; each contract represents 100 shares, at a strike price of $50. This locks in the option to buy 100 shares at $50 at a future date. At this point, you are only out the premium paid to purchase this right and could let the contract expire if the stock does not perform as expected. There is never any obligation to purchase the stock.

Types of Options: Calls and Puts

There are only two types of options, calls and puts, though there are many different strategies built around them.

Call Options

Purchasing a call option gives you the right to buy a stock at a fixed price within a set time. It is typically viewed as a bullish strategy, used when the investor believes the stock price will increase over the next few months.

Put Options

Purchasing a put option gives you the right to sell a stock at a fixed price within a set time. It is a bearish strategy, used when an investor believes a stock will decrease in price. If the stock drops, the buyer of the put option can purchase shares at the lower current price and sell them at the higher strike price for a profit.

Stock Option Strike Price Explained

The strike price, also known as the exercise price, represents the price at which an option contract can be exercised.

• For a call option, the strike price is the price at which the underlying stock can be purchased

• For a put option, the strike price is the price at which the underlying stock can be sold

Strike prices are typically set in $2.50 or $5.00 increments, depending on the underlying stock. Lower-priced stocks tend to increase by $2.50, while higher-priced stocks increase by $5.00. The strike price remains static throughout the entire option contract, unlike the share price, which fluctuates daily.

Note: The price an investor pays for an option is not the strike price; it is the premium.

How to Value a Stock Option Premium

The option premium is the amount of cash paid to the seller of the contract in exchange for the rights conveyed by the option. While the strike price and premium are distinct values, the strike price helps determine the premium, along with other factors such as time to expiration and market volatility.

For call options:

• The higher the strike price relative to the current stock price, the lower the premium, since the option is further out of the money

• The further an option is in the money, the higher the premium

For put options:

• As a stock trades lower away from the strike price, the premium becomes higher

• As the stock increases in value, the put premium becomes less valuable

What Does “In the Money” Mean?

In the Money — Calls

A call option is in the money when its strike price is lower than the current price of the underlying stock. For example, a stock trading at $20 with a call option strike price of $15 is in the money; the option owner has the right to buy shares at $15 when the current price is $20, representing an immediate $5 per share advantage.

In the Money — Puts

A put option is in the money when its strike price is above the current stock price. A stock trading at $35 with a put option strike price of $40 is in the money; the option owner has the right to sell shares at $40 when the current price is $35, representing a $5 per share advantage.

Deep in the Money

A deep-in-the-money option is generally considered to be at least one strike price above or below the current share price. Both puts and calls that are deep in the money tend to carry less risk and are valued higher than contracts with a strike price at or near the current share price.

Understanding Stock Option Expiration Dates

Unlike a stock, every option will eventually expire and become worthless if it is not exercised. This is known as the expiration date. An investor who holds a call or put and lets the contract expire without exercising it will lose the entire premium paid.

The expiration date also plays a crucial role in determining the premium; an out-of-the-money option with six months until expiration is typically worth more than one with three months remaining, because it has more time to become in the money. This concept is known as time value.

Common Stock Option Trading Strategies

Covered Calls

One of the most common options strategies is selling covered calls. Here are the basic steps:

• 1. Buy the stock. To be covered, you must own 100 shares of the underlying stock for each contract you sell. Your broker will not allow you to place the trade without these shares in your account and will require special approval to trade options.

• 2. Find out-of-the-money options. Look for call options with a strike price higher than the stock’s current share price. For example, if a stock is trading at $50, an option with a $55 strike price is out of the money.

• 3. Look for soon-to-expire contracts. Most investors who sell covered calls do not want to lose the underlying stock and prefer the option to expire without being exercised. A good rule of thumb is to look at contracts expiring no more than two months out.

• 4. Analyze the potential trade. Before placing any trade, calculate how much you will profit and what would happen if the call option is exercised. If a covered call will only net $20, it may not be worth the risk.

• 5. Place the sell order. Once the analysis is complete and the trade seems favorable, place a sell-to-open order through your brokerage.

Deep-in-the-Money Calls

Another strategy targets deep-in-the-money call options with several months to expiration. The goal is to purchase call options on quality stocks that are well in the money with little chance of falling out of the money, then wait for a price increase and sell the option back for a higher premium than the original purchase price.

Should Military Investors Trade Stock Options?

Stock options trading is an advanced strategy that carries significant risk. For most military investors, particularly those earlier in their careers, the priority should be maximizing contributions to the TSP and a Roth IRA before considering options trading. The TSP’s low expense ratios and government matching contributions under the BRS offer a stronger risk-adjusted foundation than options trading for most investors. Understanding your overall asset allocation strategy is an important first step before adding options as a component of a taxable brokerage account.

Options trading may be appropriate as a small component of a taxable brokerage account for experienced military investors who have already maximized their tax-advantaged accounts and have a thorough understanding of options mechanics. It should never be funded with money needed for living expenses or retirement.

Choosing a Brokerage for Options Trading

Options trading requires a brokerage that offers options approval and competitive contract pricing. Here are three well-regarded platforms worth considering:

Ally Invest offers commission-free stock and ETF trades with a low $0.50 per options contract fee, one of the most competitive rates available. The platform has no account minimum and integrates easily with Ally Bank high-yield savings accounts for cash management.

Zacks Trade is a boutique brokerage geared toward experienced and active traders. It offers access to Interactive Brokers’ powerful trading infrastructure with $1.00 per options contract pricing and free broker-assisted phone trades, a rare offering in the industry. The platform is best suited for advanced investors comfortable with a professional-level trading environment.

Morgan Stanley E*Trade has been an industry-leading brokerage for over two decades. The platform offers an easy-to-use app for trading on the go, with competitive options contract pricing and a wide range of research and analysis tools suitable for both intermediate and advanced options traders.

Before selecting a brokerage, confirm that options trading is available and that you meet the approval requirements. Most brokers require a separate application and approval process for options trading based on your experience level and account size.

Getting Started with Stock Options Trading

Stock options can be a powerful tool for experienced investors, offering the ability to hedge existing positions, generate premium income through covered calls, or speculate on price movements with defined risk. However, they come with significant complexity and the potential for substantial losses.

Before trading options, make sure you have a thorough understanding of all five core concepts covered in this guide: the right but not obligation, calls and puts, strike price, premium, and expiration date. Starting with paper trading, simulated trading with no real money at risk, is a good way to build familiarity with options mechanics before committing real capital.