What Are Stock Options

The burning question in a new trader’s mind is What Are Stock Options?

Stock options are contract that give the holder the rights, but not the obligation, to buy or sell an underlying asset (stocks) at a predetermined price (strike price) before or at a certain time in the future (expiration date) for a consideration (premium).

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Options are a derivative security.

That is, the price of options fluctuated when the price of another security, which is the common stock of the company, moved.

Splits and stock dividends in the underlying stock affect the terms of listed options, although cash dividends do not.

The holder of a call option is not entitle to the cash dividends paid by the underlying stocks or enjoys any voting right. unless it is exercised.

In short, stock options are just another form of investment that can be bought or sold just like a stock, a commodity or a bond.

There are four specifications uniquely describe any option contract:

  1. The type (call or put),
  2. Underlying stock name,
  3. Expiration date and
  4. Strike price

An options contract gives the owner the right to buy or sell a specified number of stocks (generally 100) of a company. The options holder can choose to exercise and convert the options to the company’s stock when it is to their advantage.

A call option gives the holder the right, but not the obligation, to buy a fixed number of shares of a company at a specific price before the option’s expiration date.

A put option gives the holder the right, but not the obligation, to sell a fixed number of shares of a company at a specific price before the option’s expiration date

As an example, the term “ABC June 11 75 call” is an option to buy (a call) 100 shares of ABC stock (Underlying stock name) at $75 (Strike price) per share. The option expires in June 2011 (Expiration date). The price of a listed option (premium) is quoted on a per-share basis. Thus if the price of ABC June 75 call is quoted at $3, buying the option would cost $300 ($3 x 100 shares), excluding commission charge by brokers.

Value of options

An option is a “wasting” asset. This means that the value will declines as time passes. It can either:

  1. Expire worthless (ie Zero value at expiration date) or
  2. Holder may exercise the option to recover some value, before the expiration date or
  3. Holder may sell the option in the listed option market before the expiration date.

When you buy an option, you are NOT obligated to buy or sell the underlying asset, you simply have the right to do so at the fixed (exercise or strike) price.

When you sell an option, you are obliges to buy (with sold puts) or to sell (with sold calls) the underlying assets when the option buyer exercises the option.

Next, find out the various Places where options are traded

Return from What Are Stock Options to Option Basics

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