What are Stock Options?
The term stock options is thrown about in the financial world with regularity, especially with technology and growth companies. Most investors have heard of stock options, however many do not understand the working parts that make them a viable trading strategy. In the following paragraph, eRollover will explain what a stock option is, how they trade, and what kind of investor should be involved with this type of securities transaction.
Introduction to Stock Options
Options are financial instruments that can provide the individual investor with
the flexibility to develop additional strategies for protecting or purchasing stocks.
In a nutshell, trading options give you options. With stock options, you're not just limited to buying, selling or staying out of the market. Consider the following potential benefits of trading options:
You can protect stock holdings from a decline in the price of the underlying security
You can produce income by trading options against current stock holdings
You can position yourself to buy stock at a lower price
You can position yourself for a big market move regardless of which way prices will move
You can benefit from a stock's rise or fall without paying the full price of buying or selling the stock outright
A stock option is a contract which conveys to its holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date. After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (or buy) the shares to (or from) the buyer of the option at the specified price upon the buyer's request.
Trading Options Compared To Common Stocks
Options share many similarities with common stocks:
Both options and stocks are listed securities. Orders to buy and sell options are handled through brokers in the same way as orders to buy and sell stocks. Listed option orders are executed on the trading floors of most national SEC-regulated.
Like stocks, options trade with a bid and an ask price for the price of the option. In options, the bids and offers are for the right to buy or sell 100 shares (per option contract) of the underlying stock at a given price per share for a given period of time.
Option investors, like stock investors, have the ability to follow price movements, trading volume and other pertinent information day by day or even minute by minute.
Despite being quite similar, there are also some important differences between
options and common stocks which should be noted:
Unlike common stock, an option has a limited life. Common stock can be held indefinitely in the hope that its value may increase, while every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument
There is not a fixed number of options, as there is with common stock shares available. An option is simply a contract involving a buyer willing to pay a price to obtain certain rights and a seller willing to grant these rights in return for the price
Stock ownership provides the holder with a share of the company, certain voting rights and rights to dividends. On the other hand, option owners participate only in the potential benefit of the stock's price movement.
Risks of Trading Options
In planning any options strategy, it is important to consider the risks of options trading. There are several factors that influence the price of an option. These include time to expiry, volatility and interest rates. As an uncovered option writer, you face potentially unlimited risk. The risk faced by the taker of an option is limited to the premium paid for the option. However, as an option writer, you face potentially large losses if the stock has a significant move in an unfavourable direction.
If a call option you have written is exercised, you must sell the underlying shares at the exercise price of the option. If the shares are trading a long way above the exercise price of the option, you may make a substantial loss.
Leverage means that you can make large percentage profits from option trades when your view on the underlying stock proves correct. However, it also means that if your view is incorrect, your losses in percentage terms will be correspondingly large.
This article on stock options, option trading, and the many features about trading call and put options has been brought to you by eRollover
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