Understanding Stock Options
A hopefully intuitive explanation of how they trade
Stock options are all the rage these days. After all, what’s better than fast-rising stocks? Options on those fast-rising stocks. The stories of traders making millions off of meme stock options or tech stock options are captivating. But they also underplay the risk of betting a significant portion of your portfolio on stock options.
Options are a levered bet on the underlying security (typically stocks, but could be anything). If you Google call options (calls are a bet on the underlying, puts are a bet against it), you usually get some version of the image below.
Let’s focus on equity call options for this post. As the price of the underlying increasingly moves above the strike price of the option (strike refers to the price at which you have the option to buy the underlying stock), your option grows increasingly in the money. Thus above the strike price, the option’s value moves virtually dollar for dollar along with the price of the underlying stock (I am assuming for simplicity that the underlying on each option is one share of stock rather than the traditional 100 shares).
