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.
Enjoy!!
Cade Arnel
Trend Hunter
www.globaltrendtraders.com © 2009-2010
Stock options can be a bit tricky to understand. When I had stock options explained to me the first time. It took a while to grasp. But once you do understand them, your eyes light up to the possibilities. You even begin to realise that having stock options can be safer than simply buying the underlying stock without options.
Hi Cade,
You’ve explained stock options really well here.
They can be tricky to understand, but like David says, when you finally get it, it’s like somebody finally turned the light on!
There’s an options group meet up at out place tonight – should be fun 🙂
Hi Jan,
Yes Stock Options are a powerful tool that you can use in the market to your advantage, knowledge and execution are the key.
I’m impressed, starting a Trading discussion group is a great way to learn and collaborate ideas also. 🙂
Great explanation Cade. I’ve been trading options off and on for a couple of years now and like most people I found them hard to comprehend at first.
My favourite trades are the covered calls but you need a fair bit in your trading account for those. A cheaper option (hehe) to covered calls are the bull put and bear call spreads.
Thanks Peter,
Yes Covered Calls is a great strategy to use in a Neutral to Bullish Market, its one that I use also.
The trick is to known what the market environment is, and what strategies are suited. 😉
Hey Cade,
Love everything options. This explains stock options very well indeed.
One of the hardest things to comprehend when learning options is being able to sit on both sides of the desk. To see both sides of the transaction. There is the writer and there is the taker. Only when you can see both sides of the exchange do you begin to comprehend the beauty of options.
Thanks John.
I agree, having a good grasp of what options are and how they work, can really speed the process of mastering Option Strategies.
Hi Cade
I think I should start reading your blog from the beginning as I have no understanding of shares but as one two of my sons are investors I need to know more about what they are talking about.
Hi Cade
My husband and I discovered options trading a year ago. We really enjoy the benefits of options trading as opposed to investing in shares. Thanks for all the info. Great blog!
As a stock options trader myself, you have done a great job explaining what a stock option is. They can be a little overwhelming at the start and I still have to stop and think about it before I enter trades, but once learnt, stock options are a great way to make some extra money.
Stock Options are contracts that grant the holder the right to buy or sell a specific stock at a specific price before the contract expires. Stock options are one of the most creative innovative and flexible financial derivative instrument that has ever been created. Learning about what stock options are is a also must for anyone who wishes to participate in options trading.
Very nice introduction– in my opinion too many websites that attempt to provide education on options don’t focus enough on writing options, which is too bad, as covered puts/calls are much safer than leverage chasing on the buy side. Everyone understands taking a fast gamble, but the subtleties of selling options should be much more interesting to new investors, especially those who have large existing portfolios.
I like the leverage of trading stock options and the extra income it brings in for stock owners with covered call writing.