When long-term investors want to invest in a stock, they usually purchase shares at the current market price. But there's a way to buy shares without paying that market price by using stock options. Understanding and knowing how to buy options can give you another tool for your investing toolbox.
- You can use stock options to buy shares of stock without paying the market prices.
- A stock option is a contract that gives the buyer the right to buy (call) or sell (put) at a specified price, on or before a certain date.
- Stock options are available on most individual stocks in the U.S., Europe, and Asia, and there are several advantages to using them.
Call and Put Options
A stock option is a contract giving the buyer the right, but not the obligation, to purchase or sell an equity at a specified price on or before a certain date. An option that lets you buy a stock is known as a "call" option; one that lets you sell a stock is known as a "put" option. If you do not exercise your right under the contract before the expiration date, your option expires, and you lose the premium—the amount of money you spent to purchase the option.
Stock options are available on most individual stocks in the U.S., Europe, and Asia. You should note that, in addition to the U.S.-style options just described, there are also European-style options. They differ from the U.S.-style ones in that you can exercise them only on the expiration date, not during the period leading up to it.
How to Buy Stocks by Using Put Options
The following strategy for buying a stock at a reduced cost involves selling put options on 100 shares of a particular stock. The buyer of the options will have the right to sell you those shares at an agreed-upon price known as the "strike price."
Beginning traders and newer investors may not have the ability to buy and sell options within their trading platform. Consider the best options trading platforms and do your research before investing as options come with lots of risk.
Once you've chosen a stock that you believe would be worth owning at a particular strike price, there are steps you can take to attempt to carry out this common type of options trade:
- Sell one out-of-the-money put option for every 100 shares of stock you'd like to own. A put option is out of the money when the current price of the underlying stock is higher than the strike price.
- Wait for the stock price to decrease to the put options' strike price.
- If the options are assigned by the options exchange, buy the underlying shares at the strike price.
- If the options are not assigned, keep the premiums received for selling the put options.
Advantages of Options
There are three main advantages of using this stock options strategy to buy shares:
- When you sell put options, you immediately receive the premiums. If the underlying stock price never decreases to the put options' strike price, you can't buy the shares you wanted but you at least get to keep the money from the premiums.
- If the underlying stock price decreases to the put options' strike price, you can buy the shares at the strike price rather than at the previously higher market price. Because you choose which put options to sell, you can select the strike price and so control the price you pay for the stock.
- The premium you received for the puts provides a small buffer between the purchase price of the stock and the breakeven point of the trade. That means the stock price will have to decline a bit further for the trade to lose money.
A Detailed Trade Example
Assume that a long-term stock investor has decided to invest in QRS Inc. QRS's stock is currently trading at $430, and the next options expiration is one month away. The investor wants to purchase 1,000 shares of QRS, so they execute the following stock options trade:
- Sell 10 put options—each options contract is for 100 shares—with a strike price of $420, at a premium of $7 per options contract. The total potential amount received for this trade would be $7,000 ($7 x 10 x 100). The investor receives the $7,000 once other investors purchase the options.
- The investor waits to see whether QRS's stock price will fall to the put options' strike price of $420. If the stock price decreases to $420, the put options may be exercised, and the put options may be assigned by the exchange. If the put options are assigned, the investor will purchase QRS's stock at $420 per share, which is the strike price the investor chose when they sold the puts.
- If the puts are exercised and the investor buys the underlying stock, the $7,000 received for the put options will create a small buffer against this stock investment, becoming a loss. The buffer will be $7 per share: the gain from selling the puts ($7,000) divided by the number of shares (1,000). This means that the investor will break even at a stock price of $413. If the stock drops below $413, the stock investment becomes a losing trade.
If QRS's stock price does not decrease to the put options' strike price of $420, the put options will not be exercised, so the investor will not be able to buy the underlying stock. Instead, the investor will keep the $7,000 received for the put options.
Frequently Asked Questions (FAQs)
How are stock options taxed?
Stock options are taxed like stocks. You will face your normal income tax rate on any gains unless you hold the option for more than a year, in which case you qualify for the lower long-term capital gains rate. The strategy discussed here involves selling the option rather than buying and holding it, so it would be considered short-term and be taxed at your normal income rate.
When do stock options expire?
Every option comes with a specific expiration date (usually a Friday, though it can be any day). An American-style option (common on most equity options in the U.S.) can be exercised at any time through the end of the expiration date. European-style options (e.g., on U.S. equity indexes) can only be exercised at expiration.