Stock Options – Introduction
Stock options are one of the most creative, innovative and flexible financial derivative instrument that has ever been created. It has found its place not only in the stock markets but also as employee benefits in order to participate in a company’s growth. Learning about what stock options are is a must for anyone who wishes to participate in options trading. This tutorial shall provide a free, in-depth look into what stock options are, the different types of stock options, how they work and much more.
What Are Stock Options?
Option is a financial instrument that is traded in derivative segment at the stock market. An option contract is a contract between the buyer and the seller. It is a contract to buy and sell a fixed number of underlying assets on or before the date on which the contract expires. As a buyer of an option contract one has the right to exercise the option contract with the time period of the contact. But the buyer of the option is not bound to exercise the option. But a seller of the option contract is bound to honor the contract if the buyer exercises his contract. The price at which the contract is decided for trade, that price is called the strike price. There can be different assets that are traded through the option contract – it can be stocks, index, commodity or other derivative instrument like future contract.
There are two different types of options that are traded at the stock market – Call Option and Put Option.
- What is a Call Option – As a buyer of the call option you will have the right to buy the asset at the agreed strike price within the time period, that is on or before the contract gets expired. As a buyer of the call option you may or may not buy the asset but the option writer who has created the option is bound to sell off the asset if you as a buyer decide to exercise the contract. For buying a call option you have to pay the premium price of the contract and if you do not buy the asset this premium amount is lost.
- What is a Put Option – This is just the opposite of the call option. In a put option you will get the right to sell the underlying asset in the strike price within the time till the contract is valid i.e. on or before the expiry date of the contract. As a buyer of the put option you can decide to sell the asset or ignore the option and let it expire. But the seller of the put option is bound to buy the asset if you decide to sell.
- How option contracts traded at the stock market – Like any other forms of derivative trading, in option trading as well stocks are bought and sold in lot. Depending of the stock and the price the number of stocks in one lot decided. The price of the lot is derived by multiplying the current price of the stock and number of stock in one lot. For buying the option contract you have to pay the premium to the writer of the option contract. If you think that price of stock is going to rise, you can buy the call option and if the stock performs the way you expected you can exercise the call option. On the other hand if you think that price of the stock will fall you can buy the put option and exercise that option when the price falls according to your expectation.
Benefits of trading in stock options
1. Less risk. Most people assume that options have higher risk then stocks because you can lose 100% of what you invest. While this part may be true the amount you invest with options is lower than what you would invest with if you buy the stock. For example an option on a $50 stock may be just $3. Because of this you are only risking $3 on the trade. If you had bought the stock you would be risking $50.
2. Higher profit potential. Stock movements are magnified with options. If a stock moves up 10% that could mean an option will move up hundreds of percentage point. Because they are so highly leveraged a small move in a stock could mean a big move in the option.
3. Options can take advantage of all market directions. While call options make money when a stock goes up, put options make money when a stock goes down. This can be very beneficial in a bears market when it is hard to find stocks that are going to rally but easy to find stocks that are going to tank.
4. Options can be bought and sold. Because of this option not only let you take advantage of what a stock is going to do, but they also let you take advantage of what a stock is not going to do. That can be helpful when a stock doesn’t do much at all.
5. They help you to get out a losing trade faster. Most new traders will buy a stock and watch it fall. These traders do not sell their stock because they expect it to go up in the long run. So they hold onto it and watch their loss get bigger and bigger. If they had an option on the stock they would have been able to take a small loss and move onto the next trade.