What Are Stock Options?

10/30/2014 8:00 am EST

Focus: OPTIONS

For those traders who have not ventured into the world of options yet, now is the perfect time to jump in with both feet. Here, David Frank, of FXEmpire.com, outlines all the basics of options so that anyone can start trading them.  

A stock option is a stock substitute. It has higher leverage and it requires less initial capital or outlay of funds. Options are used to bet on the direction of the underlying security just like buy or shorting the actual stock itself. However, stock options have different characteristics and terminology.

There are two basic types of stock options for e-traders. First, there is the call option, giving you the right to buy the stock at the strike. The second is when you buy a put option, which gives you the right to sell the stock at the strike price. An options contract gives you the right to buy or sell before the expiry date of the contract.

The big difference between owning a stock or an option is simple. Owning stock in a company gives you ownership. Options are contracts that give you the right to buy or sell the underlying stock at a certain price at a specific time. There are two important sides to every stock option contract. The buyer and a seller. Every time you buy a call or a put option, there is always a seller.

When you sell an option you are creating a security that did not exist before. This is called writing an option and becomes a major source of options where neither the underlying company nor the options exchange is involved. When you write a call you are obligated to buy the underlying stock at the strike price and before the contract expires.

Trading stocks and gambling casinos are akin and virtually the same thing. In both cases, you are betting against the house. If you get really lucky and have a good winning streak, you can win a lot of money. Trading options is like betting on a horse at the racetrack. People are betting against each other and the track takes a small piece of the pie for lending its facilities. Trading options is a zero-sum game. What is this? The more the option buyer wins the more the seller loses.

Pricing Options

The price of a stock option is also called the premium. A buyer of an option can only lose his premium and now more. He can only lose what he paid for the contract, no matter what the underlying security does. The risk is never more than the initial amount paid for any option. The potential profit is technically unlimited.

In return for the premium the seller receives, the seller must also deliver the stock, if it's a call option or receive the shares or stock if it is a put option. If the option is not covered by another, the seller's loss is opened ended. In other words, the seller can lose much more than the original premium.

NEXT PAGE: Types of Options and Importance of Terminology

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Two Basic Option Types

There are two types. The first is an American-style option. This is an option that can be exercised anytime from the purchase date to the expiration date. American-style options are the most traded of the types. The other type is a European-style. These can only be exercised on the expiration date. The most common type of European-style options are index options.

When the strike price (the price to generate purchase of the underlying security) of a call option goes above the stock price, it is out-of-the-money. When the strike price is below the stock price, it is called in-the-money. A put option is just the opposite. When the option is above the stock price, it is in-the-money. When the strike price is below the stock price, it is out-of-the-money.

Prices for options are usually at intervals from $2.50 to $30. After that they increase by $5 steps. Also, only strike prices around a reasonable range are traded. The chances of a large in- or out-of-the-money is not very likely. All stock options expire on a certain date. This is called the expiration date. Normally they go out as much as nine months from the date of listing. Longer-term contracts are called LEAPS and are available for many exchange listed stocks. They can go out as much as three years from the listing.

Stock options expire the third Friday of the month of expiration. In reality, they expire on the third Friday. Why? Your broker is usually unavailable on a Saturday. Also, exchanges are closed. Broker-to-broker settlements happen on Saturdays.

Buying and selling stock has a three-day settlement period. Options settle next day. This means, to settle on a Saturday, you must exercise the trade by the end of business on Friday.

Many option traders use options within their larger investment strategy. Taking into account their stock portfolios and what they hold depends on what options they buy. Options are used to hedge against wild market swings and keep losses to a minimum. Because options trading is a different animal from trading stocks or equities, a trader must learn the terminology in order to make good investment decisions.

Terminology with options is very important. A trader needs to learn the different vocabulary terms, like strike price, contract, long a call option or short a call option. Same goes for put contracts. Remember, you do not own the underlying security but own a contract that gives you the right to either purchase the underlying security at a certain price or sell it at a certain price. This makes understanding terminology key. You need to know which option is right for your portfolio. Especially since options are often used to hedge and protect any downside risks and to help prevent losing too much profits. As one learns how to trade stock options, you will realize how key ownership is to help increase profits. In the end, options are a cornerstone in any financial portfolio. Especially those who have long-term assets, which are exposed to any geopolitical or general economic news risk.

By David Frank of FXEmpire.com

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