The number one thing that prevents most stock traders from learning how to trade stock options, is the incorrect beliefs about what options are, and what they offer.
So the best way to overcome these beliefs is to have Stock Options Explained, so I am going to feature a two part series to cover this topic in a some detail.
So lets take a look...
So what is the definition of a Stock Option...
A Stock Option is a financial derivative instrument which establishes a contract between the buyer and the seller of a designated asset.
There are only two types of Options, they are a Call Option and a Put Option.
Because in every Stock Option contract, there is a Buyer and a Seller, I will explain the difference between a Call Option and a Put option, from the perspective of both the Buyer and the Seller.
The difference between a Call Option and a Put Option...
Buying Stock Options
When you buy the option, you are the Option Holder.
- As a Holder (Buyer) of a Call Option, you have the Right, but not the obligation, to Buy the asset (stock) at the strike price, should you choose to exercise the option, on or before the contract expiry date.
- As a Holder (Buyer) of a Put Option, you have the Right, but not the obligation, to Sell the asset (stock) at the strike price, should you choose to exercised the option, on or before the contract expiry date.
The Option Holder, after buying the option, is looking for the option to increase in value, so the option can be either sold at a profit, or exercise the option at a better price than the current price.
Selling Stock Options
When you sell an option you are the 'Option Writer', as you are creating the option.
- As a Writer (Seller) of a Call Option you have the Obligation to the Buyer, to Sell an asset (stock) at the strike price, should the buyer choose to exercise the option, on or before the contract expiry date.
- As a Writer (Seller) of a Put Option you have the Obligation to the Buyer, to Buy an asset (stock) at the strike price, should the buyer choose to exercise the option, on or before the contract expiry date.
The Writer, after writing (selling) the option, pockets the premium (cost of option), and is looking for the option to decrease in value, if not expire completely worthless.
During the life of an option (after being first written), an option may be bought and sold many times as the price of that option fluctuates, but the contract is always between the original writer and the current option holder.
So it's a completely different mindset for selling options to buying options. As you will see, in the following article, I will uncover how Stock Options can help your Portfolio.
So here are a few facts that help further explain Stock Options:
- In the US Option Market, each (1) option contract controls 100 shares of a security (in Australia is 1 for 1000 shares).
- All Option Contracts are good up until a defined expiration date, after which point, the contract becomes null and void.
- The designated Price at which the stock can be purchased or sold is the Strike Price.
- As the option prices are based upon the value of an underlying security(stock), they are referred to as derivatives.
The Cost of Stock Options Explained:
- The premium, or cost of an option is mainly determined by:
- The Intrinsic Value, which is always derived from difference between the stock price, the strike price.
- The Extrinsic Value, which is derived from the time remaining until expiration, and the volatility of the stock and or market.
- The Intrinsic Value of a Call Option = Stock Price -Strike Price . (Not less than zero.)
- When the stock price goes up, the value of a Call Option also goes up.
- The Intrinsic Value Put Option =Strike Price - Stock Price.
- When the stock price goes down, the value of a Put Option goes up.
- Extrinsic Value of an Stock Option decreases over time, to a point where the Extrinsic value is worthless at or close to expiration.
The first time I had Stock Options Explained to me, was the day I realized the power of Stock Options. I also realized I didn't have to know every Stock Market Options Strategy in the book, just to be good at a few that suited my style. So it is worth getting some Advanced Option Trading Education to learn all you need to know to be successful with those strategies.
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