Stock Option Trading Education
An option is a financial security like stocks and bonds, and is a legally binding contract. According to Investopedia, an option "is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset." The buyer of the option may buy or sell the option's underlying asset, such as shares of a company stock, on or before a particular date, which is defined at the time of forming the options contract.
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In order to appreciate the principles of stock options trading, it is important to understand how it works. Suppose that you want to buy a used car from its owner. The owner asks $3,000 for the car, but you do not have adequate funds to buy it right away. In this case, you might negotiate and go into an agreement with the owner. You agree to buy the car in six months for the asking price of $3,000, but have to pay the owner an additional $500 for the option. Under this options contract, you pay the owner the price of the option ($500) right away, and have the right to buy the car for $3,000 in six month's time.
Implications
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An option gives the buyer a right to take a certain action. In the above example, you, as buyer of the option, have the right to buy the car but are not obligated to do so. Not buying the car on or before the due date will invalidate the contract and you will lose the price you paid for the option ($500). It is important to understand that the buyer of an option only loses the price paid on purchasing the option, and not the value of the underlying asset, which in this case is a car valued at $3,000.
Since an option derives its value from an underlying asset, it is referred to as a financial derivative. Typically, the underlying asset in an option is company stock.
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Terminology
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In stock options trading, buyer are "holders" and sellers are "writers." Holders are not obligated to exercise rights of the contract, but may choose to do so. Writers on the other hand are obligated to buy or sell, depending on the holders' preferences. Another term routinely used in stock options trading is "strike price," which refers to the threshold price of the underlying asset. In trading stock options, the price of a company stock must go above or below, depending on the type of option, before the option can be exercised.
Call And Put Options
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In trading stock options, a "call" option gives the holder the right to buy a particular stock at a defined price by a certain date, and a "put" option gives the holder the right to sell a particular stock at a defined price within a certain date. For a call option holder, the stock price should increase in market value substantially in order to make a profit. For a put option holder, the stock prices should decrease in value.
Premium And Listed Options
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The price of an option, referred to as premium, does not include the price of the underlying asset, but is derived from it. Other factors that determine the premium include, strike price, expiration date and volatility of the stock.
Options that are traded on formal exchanges, such as the CBOE (Chicago Board Options Exchange) are called listed options. The contracts, with predefined expiration dates and strike prices, have 100 shares of a company's stock as their underlying assets.
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