What are Stock Options Basics
Stock option investing is a popular way to speculate
on particular stocks. Here is a look at what are stock
A stock option is a contract that gives a buyer the right to buy or sell 100 shares of a stock at a specific
price by a certain date. The option holder can exercise the right to that option any time before the option
expires. The contract doesn’t obligate the buyer to exercise that right. It just gives them a choice to
exercise the right. Stock options are called derivatives because their value is derived from the underlying
stock rather than from the contract itself. Without the stock, the option contract has no value of its own.
Stock Options Basics
There are two types of options: calls and puts.
A call option gives the buyer the right to buy stock a certain price by a certain time. A buyer with a call
stock option hopes the price of the stock increases before the option expires. That way, the buyer can
purchase the stock for a price that’s lower than the current share price. Then, after the buyer has
exercised his call option, he can sell the stock at the higher market price and make a profit.
A put option gives the buyer the right to sell stock at a certain price by a certain time. These buyers hope
the stock price falls before the option expires. That would allow them to sell the asset at a price that’s
higher than the current market share price.
With each type of stock option there are two different participants – buyer of the option and a seller of the
option. Buyers are called holders and have a long position on the stock option, while sellers are called
writers and have a short position.
While stock option buyers have the right to buy or sell the option, sellers are required to buy or sell the
stock if the buyer chooses to exercise their right. For example, if you sell a call option and the buyer
decides to purchase the stock before it reaches a lower price, you’re required to sell that stock, even if
the price isn’t favorable to you.
Parts of a Stock Option
There are a few important pieces of the stock option
contract. The strike price is the price at which the stock
can be bought (call) or sold (put). For the holder to make
a profit on a call option, the share price needs to go
above the strike price. For holder to make profit on a
put option, the share price needs to go below the strike
Options are in-the-money when the share price reaches
a level that’s profitable for the option holder. A call option
is in-the-money when the share price goes above the
strike price and a put option is in-the-money when the
share price goes below the strike price. The intrinsic
value is the amount that the option is in-the-money.
The holder has to pay a price, or premium, for the stock option. Stock option premiums are based on
several difference factors include the stock price, strike price, amount of time until the option expires,
and the volatility of the stock.
The exercise period lasts from the time the option is purchased until the expiration date. If the holder
doesn’t exercise the option before it expires, then the stock option becomes worthless.
When Would You Buy an Option?
You might buy an option if you think (or hope) stock prices are going to move in a certain direction. If you
don’t exercise your option by the expiration date, you’ll lose the money you put into the option, but it can
save you from losing even more money by exercising an unprofitable option. You might also purchase an
option as sort of an insurance policy or hedge to minimize your losses in case a stock price doesn’t
move in the direction you hoped.
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