Options Trading Rules
Option trading rules pertain to a set of procedures related to a legally binding contract between two investors to buy or sell the right to instruments, such as stock, stock indexes or commodities. The contract can be purchased at a specific price and for a predetermined time. Individuals called "options writers," sell options to individual investors. In the United States, stocks options are traded on six different option exchanges. Many investors trade options because they may profit on the movement of a stock without having to buy it outright.
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Function
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Options are used to serve a variety of investment goals; some investors use options to generate income from stocks they already own within their portfolios. Another popular reason traders invest in options is to hedge their stock positions and protect against losses. Other individuals may purchase options purely on speculation and the chance to profit from buying or writing options. Many sophisticated traders have the knowledge and skills to implement multiple trading strategies by using a combination of put and call options.
Puts and Calls
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Under option trading rules there are two kinds of options: puts and calls. Investors can either buy a call or sell a put. An investor who buys a call has the right to purchase the underlying stock, or commodity, at a certain price point on or before option's expiration date. The price is called the strike price. Purchasers of put options have the right to sell the instruments expiration. Many investors use various combinations of both classes of options to profit in all types of market conditions.
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Option Writers
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Investors, who write options, or sell to open transactions, are obligated to honor their side of the contract if the buyer exercises the option. For example, a writer who sells a call of ABC stock must sell the stock at the strike price, if assigned. Writers who sell put options promise to buy the underlying asset, if assigned. Option trading rules permit option writers to buy back contracts by purchasing an offsetting contract right up to being assigned. This type of deal is called a "buy to close" transaction.
Option Contract
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Although stock option prices are quoted in price per share, they are sold in lots consisting of 100 shares. An option price quote at $2.50 means that the price for the option is $250. The strike price represents the cost to buy or sell the underlying asset up to the day the contract expires. The strike price is also call the excise price.
Both put and call options are classified by the month of expiration and the quoted strike price. A put option for ABC stock that has a strike price of 30 and expires in April would be identified as "ABC April30 Put." All options contract expires on an expiration date, which is usually on the third Friday of the month. If expiration Friday falls on a holiday, the option expires on Thursday.
Premium
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The purchase price of an option is called the premium. Option writers receive premiums for assuming the risks of selling options. Premiums are not fixed; on a day-to-day basis, they can be higher or lower, based on market conditions. The premiums reflect the prices buyers are ready to pay and the price sellers are prepared to accept for a particular option. Options buyers start out with a net debit, which means that investors understand there is a chance of losing the money spent on option purchases unless they exercise their rights or sell for a profit.
On any money made from buying or selling options, the investor must account for the cost paid for the premium to determine their net profit. Since option sellers, collect the premium, they begin with a net credit. If the buyer does not exercise the right to buy the underlying asset, the seller can keep the premium. In cases where the buyer exercises the right to buy the stock, the seller keeps the premium, but must sell the underlying stock or commodity.
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