Explaining Stock Options for Beginners
The investing world provides many ways for a trader to gain exposure to different assets. In the stock market, you can invest in equities to gain exposure to the company’s profits and success. Meanwhile, toi invest in stocks, you can buy them directly. Or you can use stock options.
What is a Stock Option?
A stock option provides an investor the right but not the obligation to buy or sell a stock at a predetermined price and date.
Two types of options exist: puts, which is practically a bet for a stock to weaken, and calls, which is practically a bet for a stock to rise.
Styles of Options
There are two main styles of options, which are the American and European. The names completely don’t have anything to do with geography.
You can execute or exercise American options at any time between the purchase and expiration date with the counterparty you’re dealing with. American options are pretty common.
On the other hand, European options are not as common as the American options. You can exercise European options only on the expiration date.
Not only do options allow a trader to speculate on the rise or fall of a stock, they also let the trader choose a specific date on which they expect the stock to rise or fall. This is what we call the expiration date.
The expiration date is important because it is useful for the trader to price the value of the put or the call option. This is called the time value.
Time value, meanwhile, is used in different option pricing models including the Black Scholes Model.
The strike price refers to the price at which the stock option should be exercised. This is the price that a trader anticipates the stock to be higher or lower than when the expiration date comes.
If you, for example, are betting that Company A is going to rise in the future, you might buy a call option for a particular month at a particular strike price.
Contracts refer to the number of options that a trader may be looking to purchase. One contract is 100 shares of an underlying stock.
Using the previous example, a trader wants to buy five call contracts of Company A. Say that the trader thinks the stock will rise above $150 by the middle of March. The trader then would own five March $150 calls.
If the stock of Company A indeed rises above $150 by the expiration date, the trader has the option to exercise the contract i.e. to buy 500 shares of Company A’s stocks at $150, regardless of the current price.
He also has the option to let the contracts expire without exercising the right to buy shares if the price doesn’t rise above $150. The contract will then be worthless.
The trader’s loss will be limited to the price he spent to buy the options contracts. And this price is what we call the premium.