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What is a Stock Option?
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Stock Options - What is it?
A stock option is a contract between 2 parties (a buyer and a seller) that gives a person (the buyer of the contract) the right, but not the obligation, to exercise the contract on or before a fixed future date (the exercise date or expiration) to buy or sell the underlying stock
at an agreed price.
Stock Options - How it works
If you purchase a stock option for the right to buy the shares of XYZ company for $10 today, you can exercise that right to buy XYZ company's shares at $10 anytime in the future before the contract expires no matter
what price XYZ's shares may be trading at that time. (Imagine that stock trading at $100 and you own the right to buy it for only $10!) Hence buying and selling stock options is not the same as buying and
selling the shares itself. You are actually buying and selling the right to buy or sell the underlying asset at certain pre-determined prices.
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Stock Options - Expiration
The rights conferred by stock options do not last forever as stock options contract has a fixed expiration date. Stock options expire on the third Friday of each expiration month in the US Markets. This is known as the
Expiration Date.
Stock Options - Derivative Product
Because a stock option is defined in terms of its relationship to an underlying stock, stock options are referred to as "Derivatives". Like
futures and warrants, derivatives are fast becoming an asset class that are well known for its leverage and hedging potentials.
In fact, there are times when stocks can be riskier than options.
A stock option contract is based on an underlying stock. Other financial instruments that also have option contracts written on them are
Forex, Index, ETFs, Commodity and even Real Estates. Basically, every financial asset that can be bought and sold can have options written between
potential buyers and sellers.
Types Of Stock Options
There are 2 types of stock options : Call option and Put option. Put options give the holder the right to sell the asset for a specified price, called the strike price. Call options give the holder the right to purchase the asset for a specified price.
When the holder of an option contract uses the rights conferred to him to buy or sell the underlying asset, it is known as to "Exercise" the option.
Styles Of Stock Options
There are 2 styles of stock options : American Style Options and European Style Options. American Style Options can be exercised at any time from the date of purchase up to and including the expiration date. Most exchange-traded options are American-style.
European Style Options may be exercised only on the expiration date. To option traders buying and selling stock options, the styles make very little difference as rarely do option traders exercise their stock options.
 There is still a widespread misunderstanding
amongst option traders that stock options traded in the US Markets are American Style Options and that stock options traded in European markets
are European Style Options. That is not true. Most stock options traded in European markets are American Style Options. Hence,
American or European style are merely terminologies referring to the two different styles of stock options. More and more commonly around the world,
European style options are being named as "Warrants" instead.
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Other Forms Of Stock Options
LEAPS : Options with very long expiration months (9 months or more in the future) are known as a LEAPS. A LEAPS stands for Long-Term Equity Anticipation Securities. As long term in the money LEAPS call options behave almost exactly like its
underlying asset, it is a great way to control the same quantity of the underlying asset at a discount or to leverage the same amount of money to
control more quantity of the underlying asset.
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Many option traders, including financial institutes, today
still refer to LEAPS as simply "LEAP". LEAPS is a copyrighted term and ought to be used as it is.
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FLEX : FLEX stands for Flexible Exchange Index options. It enables option traders to customise key contract terms like expiration date,
exercise style and exercise price. FLEX also extends to equity options or stock options and are known as E-FLEX. Trading of FLEX options are generally
open only for large institutes which fulfills their stringent financial requirements.
Exotic Options : Non-standardized options with special conditions attached.
Read More About Exotic Options Here!
Not All Stocks Offers Stock Options
However, not all stocks offer stock options for option trading over the exchanges. Stocks that do have stock options for option trading in the exchanges are known as "Optionable Stocks". A company
must fulfill the following criteria before their stock options are allowed to be traded publicly:
1. The closing price must have a minimum per share price for a majority of trading days during the three prior calendar months.
2. The company must have equal to or more than 2,000 shareholders.
3. The company must have equal to or more than 7Million publicly held shares.
4. The stock must be listed on the NYSE, AMEX or Nasdaq.
Companies without publicly traded stock options may still have stock options circulating within the company and one common form is an
Employee Stock Option.
The above are only requirements generally required by all exchanges. Specific listing criteria change from time to time and from exchange to
exchange. Some exchange even requires a qualitative check on the type of company and its potential before allowing their stock options to be publicly
traded. (This paragraph was included in response to a question by a reader.)
Read The Full Tutorial On Stock Options Now!
STOCK PICK MASTER!
"Probably The Most Accurate Stock Picks In The World..."
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What is Option Trading?
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Option Trading, or options trading, is simply the trading of stock option contracts over an exchange. As option trading is most common conducted through online option trading
brokers, it is also commonly known as Online Option Trading or even Online Optiontrading.
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There are many people who also lump option
trading and futures trading into one term known as Options Futures or Futures Options or Futures Option Trading and take it
to mean the same thing. It must be clarified here that Options and Futures are two
distinctly different forms of financial instruments and cannot be referred to as one single study. Futures Options are options written on futures
contracts and is again a distinctly different trading instrument. The options that are traded in the stock exchange are commonly index options
or equity / stock options
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There are currently six exchanges in the United States that list standardized options contracts based on underlying stocks -- The Philadelphia Stock Exchange (PHLX), American Stock Exchange (AMEX) and NYSE Arca in New York City, and the Chicago Board Options Exchange (CBOE) which are all open-outcry marketplaces, and the International Securities Exchange (ISE) and Boston Options Exchange (BOX) are electronic marketplaces.
A trader can trade options through any brokers which offer options trading facility. An option broker enables you to buy and sell options in
any of the above exchanges.
There are 2 classes of options, CALL OPTIONs and PUT OPTIONs. Both classes not only takes care of bullish as well as bearish markets, both classes can be Longed (to buy in order to establish a position) as well as Shorted (to sell in order to establish a position... much like you short a stock.) ! This have led to an almost limitless combination of possible option strategies that can perform wonders like profiting from BOTH an up or down move, and even to profit when the underlying stock stays stagnant!
Why Option Trading?
Successful Investors like Robert Kiyosaki and Robert G Allen have popularised the use of options trading through the use of options strategies as part of an overall strategy to financial freedom.
They preach that option trading is the investment of the rich. So, what makes option trading so powerful?
Option Trading Grants Unprededented LEVERAGE!
Yes, option trading is LEVERAGE! You can potentially make up to 10 times more money on the same move in the underlying stock versus simple stock trading!
Even though option trading was not meant to be a leverage tool but a hedging tool, it is still a great way to profit while risking only very little money.
The Leverage effect of option trading also allows an investor with very little money to participate in the move of a high priced stock as stock options
cost only a fraction of the price of its underlying stock. Apple (AAPL) is trading at $93.65 today but it's call option costs only $1.70. Which means
that an investor with only $170 can participate in the same move on Apple as would an investor with $9365 by buying its call option. That's another
benefit of option trading.
Option Trading Grants Unprededented PROTECTION!
While option trading grants you leverage, it also grants you PROTECTION! When a stock moves AGAINST you disfavorably, an option trader potentially lose much
lesser than the stock trader. Why? Because your maximum loss is limited by the price you paid for the option which could be just 10% of the price of the stock!
Taking our Apple example from above, the stock trader's maximum risk is $9365 while the option trader's maximum risk is $170 for controlling the same
number of underlying stock.
As stock options are meant to be a hedging tool in the first place, it is also a great way to protect your stocks from dropping in value by buying
the same number of put options as the number of shares that you own. In this case, put options act as an insurance policy, protecting your shares from
dropping in value.
Option Trading Grants Unprededented FLEXIBILITY!
Option Trading allows you to profit from every possible move in the underlying asset! Up or Down or Stagnant, there is an option strategy that
allows you to profit from that move. An option trader can easily participate in a downwards move on a stock through buying a put option without
having to risk margin calls by going short the underlying stock or futures.
Yes, there are even times when stock trading is riskier than option trading! Read about How Stocks Can Be Riskier Than Options.
How Does One Start Option Trading?
The easiest way to start option trading is by opening an online option trading account with a broker which offers online option trading and
then practise buying call options for stocks which you think will go up and buying put options for stocks that you think will go down. After you
are completely familar with trading call options and put options, you can then move on to the more complex option strategies.
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What is a Call Option?
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A call option is a financial contract between two parties, the buyer and the seller of this type of option based on an underlying financial instrument.
In option trading, it is simply labeled a "call". The buyer of a call option has the right, but not the obligation,
to buy an agreed quantity of the underlying asset
from the seller of that call option before the call option contract expires at a certain time (the expiration date) for a predetermined, agreed price (the strike price).
In layman terms, a call option is a contract that allows an option trader to buy a stock at a fixed price no matter what price the stock may be trading
at now. A call option contract expires when its fixed expiration date is reached.
For example, if you buy a Call option on a stock with a strike price of $10 and an expiration date 2 months later,
you have the right to exercise the right to buy that stock at $10 no matter what price the stock may be before the 2 months period is up.
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Taking Profit On In The Money Call Options
Yes, if the price of the stock rises to $15 before the call option expires, you have the choice to exercise that call option and buy that same stock
for the agreed $10 from the seller and then sell that stock immediately for $15, thus making a profit of $5. Alternatively, you can simply sell that
same call option contract to another interested buyer for a profit of $5 (because you are selling the right to buy that stock for $10 when it is now
$15, so, naturally, there is a $5 built in value inside the option contract, making it worth $5 more than you bought it for.).
Read more about Options Moneyness now.
Leverage Effect Of Call Options
As a call option contract costs only a small fraction of the price of the underlying stock but allows an option trader to profit from the same move in
the underlying stock as would a stock trader, this creates a Leverage effect. In the above example, that call option contract probably cost you
about $1 to buy (instead of $10 for the stock) and then if the stock rises to $5, a stock trader would make only 50% profit ($5 / $10) but an option
trader would make 400% Profit! ([$5 - $1] / $1)
Buying a call option is therefore a great way to control the same profit on a stock with only a small fraction of the money and therefore,
at a far lower risk than stock traders as the most you can lose is that $1 on that option contract and not the full $10 if the stock crashes. This is
therefore a great way to make a lot of money using very little money instead of risking a lot of money to make very little money.
Call Option Buyer And Seller
The seller (or "writer") of a call option is obligated to sell the underlying asset to the buyer should the buyer so decide.
Commonly, you will buy a Call Option if you are of the opinion that a stock will move upwards and conversely, you will sell or "write" a Call Option if you are of the opinion that a stock will move downwards.
Addressing A Call Option
A Call Option is addressed in the format of "Expiration Month, Strike, Type". A call option that expires in May at the strike price of $44
is referred to as a May44Call. Similarly, a call option that expires in December at the strike price of $50 is referred to as a Dec50Call.
Call Option Chain
A stock trader gets the price of a stock through a Stock Quote, Option Traders gets the price of a call option through an Option Chain. A call option chain
is a list of call options available on a stock across all strike prices. Below is a picture of a call option chain.
Notice that you get to choose from different expiration months (the months on top) and from different strike prices (the prices in the center).
This is how a typical call option chain looks like. Notice also that put option chains are also usually quoted beside the call option chain on the right hand
side. Each of these strike prices allows you to buy the underlying stock (the QQQQ in this case) at that price. If you buy the $42 strike call option (known as the April 42 Call)
for $2.50 (yes, you always buy at the "Ask" price and sell at the "Bid" price), you get to buy the QQQQ at $42 at anytime even though the QQQQ is
trading at $44.34 now.
Of course, you will never make any money by buying the April 42 call option now, exercise the call option, buy the QQQQ at $42 and then selling it immediately
at its prevailing price of $44.34. Why? Because you would make only $2.34 while you would have paid $2.50 to buy that call option contract. Yes, that difference
in price has already been priced into the call option and that is why you can see from the chains above that it gets more and more expensive as
the call option strike price becomes lower and lower. Read more about how stock options are priced here.
Profiting From Call Options
Therefore, the only way to make money from buying a call option is for the price of the underlying asset to go up. Call Options allows one
to profit from a rise in price in QQQQ by spending only $2.50 instead of buying it at $44.34. Buying call options in order to profit from
a rise in the underlying asset is the most basic way of option trading. Alternatively, if you think the underlying asset will go down, you
could play "book maker" by selling a call option to another buyer. If that buyer is wrong about the underlying stock going up, you will
profit from the price he paid you for the call option. This selling of a call option to another buyer in order to open a position is known
as to "Write" a call option. Writing a call option when you do not actually own the underlying stock is known as writing a naked call. This
puts one in the obligation of buying the stock from the market and selling it to the buyer of the call option should that buyer decide to
exercise the call option. Understanding how to completely profit from buying and writing call options is definitely
the first and most basic step to option trading. Only after one has completely understood how buying and writing of call options and put options
work can one move on to learning more complex option strategies.
Read The Full Tutorial On Call Options.
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As shorting or "writing" of call options
requires a significant margin requirement, it is not usually a strategy that beginner option traders with very small funds can execute. There
are brokers who requires a cash reserve of about $100,000 before you are allowed to write a single call option. Therefore, for beginner option
traders who wants to profit from a downwards move in the underlying stock, buying a put option would be a lot easier.
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Read The Best Option Trading Books Recommended By Hedge Fund Managers!
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What is a Put Option?
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A put option is a financial contract between two parties, the buyer and the seller, of a put option based on an underlying asset.
A put option behaves opposite to a call option and allows the buyer of the put option to profit from a downwards move in the underlying asset.
Put options are often simply labeled a "put". The buyer of a put option has the right, but not the obligation, to sell an agreed quantity of the underlying asset to the seller of the put option before the contract expires at a certain time (the expiration date) for a predetermined, agreed price (the strike price).
In layman terms, a put option allows you to sell a stock at a fixed price before the put option expires. For example, if you buy a Put option on a stock with a strike price of $10 and an expiration date 2 months later,
you have the right to exercise the right
to sell that stock at $10 even if the stock is trading only at $5, before the 2 months period is up.
Yes, using a put option, you can "buy" a drop in the price of a stock and profit when the underlying stock declines in price without the margin requirements of shorting the stock or its futures!
A put option is therefore one of the most convenient financial instrument for use in profiting from a drop in the price of a stock.
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Taking Profit On In The Money Put Options
In the above example, if the stock drops from $10 to $2, your put option would be worth $8 upon expiration because the writer of the put option
is obligated to buy the underlying stock from you for $10 while it is worth only $2 right now. In this case, you can either buy the underlying stock
for $2 and then exercise the put option to sell it to the writer for $10, making a $8 profit or you can simply sell the put option to another buyer
for the invested value of $8.
Read more about Options Moneyness now.
Buyer And Seller Of Put Options
The seller (or "writer") of a put option is obligated to buy the commodity or financial instrument from the buyer should the buyer so decide.
Commonly, you will buy a Put Option if you are of the opinion that a stock will move downwards and conversely, you will sell a Put Option if you are of the opinion that a stock will move upwards.
Addressing A Put Option
A Put Option is addressed in the format of "Expiration Month, Strike, Type". A put option that expires in May at the strike price of $44
is referred to as a May44Put. Similarly, a put option that expires in December at the strike price of $50 is referred to as a Dec50Put.
Put Option Defensive Strategies
Put options can be used defensively in a number of ways to protect a portfolio of stocks. 2 very common ways are through the use of
"Married Puts" and "Protective Puts".
Put Option Chain
A stock trader gets the price of a stock through a Stock Quote, Option Traders get the price of a put option through an Option Chain. A put option chain
is a list of put options available on a stock across all strike prices. Below is a picture of a put option chain.
Similar to the call option chain, you get to choose from different expiration months (the months on top) and from different strike prices (the prices in the center).
This is how a typical put option chain looks like. Notice also that call option chains are also usually quoted beside the put option chain on the left hand
side. Each of these strike prices allows you to SELL the underlying stock (the QQQQ in this case) at that price. If you buy the $46 strike put option (known as the April 46 Put)
for $1.69 (yes, you always buy at the "Ask" price and sell at the "Bid" price), you get to sell the QQQQ now at $46 even though the QQQQ is
trading at $44.34 now.
Again, you will never make any money by buying the April 46 put option now, buy a corresponding number of QQQQ for $44.34, exercise the put option, and then selling the QQQQ immediately
at $46.00, above its prevailing price of $44.34. Why? Because you would make only $1.66 while you would have paid $1.69 to buy that put option contract. Yes, that difference
in price has already been priced into the put option and that is why you can see from the chains above that it gets more and more expensive as
the put option strike price becomes higher and higher. Read more about how stock options are priced here.
Profiting From Put Options
So, the only way to profit from a put option is for the underlying asset to drop in price. Traditionally, if a stock trader wants to speculate a
downwards move in price, that stock trader would have to short the stock, thereby incurring margin requirements and run up to unlimited losses should the
underlying stock continues to rally (that was exactly how many stock traders lost their shirt in the stock market). An Option Trader would be able
to participate in a downwards move simply by buying a put option. If the option trader is wrong about the stock moving down, all that the option trader
would lose is the money put forward in buying the put option. Period. A stock trader who shorted the stock would run into unlimited losses, possibly running
into bankruptcy. This is also why option trading is so preferred today. It's flexibility allows one to profit in both up and down markets with limited
risk but a leveraged reward.
Alternatively, if an option trader is of the opinion that the underlying stock will go up, that option trader can SELL or "Write" a put option
to another option trader who is speculating a downwards move on the underlying stock. If the latter option trader is wrong, the "Writer" of the put
option makes the amount of money put forward by the latter in buying that put option. Selling or "Writing" a put option when you do not actually
intend to own any of the underlying stock is known as writing a naked put. This puts one in the obligation to buy the underlying stock should the
buyer of that put option decide to exercise the put option. Only after one has completely understood how buying and writing of call options and put options
work can one move on to learning more complex option strategies.
Read The Full Tutorial On Put Options.
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As shorting or "writing" of put options
requires a significant margin requirement, it is not usually a strategy that beginner option traders with very small funds can execute. There
are brokers who requires a cash reserve of about $100,000 before you are allowed to write a single put option. Therefore, for beginner option
traders who wants to profit from an upwards move in the underlying stock, buying a call option would be a lot easier.
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STOCK PICK MASTER!
"Probably The Most Accurate Stock Picks In The World..."
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What Is The Structure Of An Option Contract?
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An option contract specifies:
whether it is a put option or call option
the underlying security
the strike price or exercise price
the Expiration Date of the contract
quantity of the underlying security represented by each contract. By default, each equity or stock option contracts represents 100 shares.
Price of the contract.
The Price of each option contract is made up of Intrinsic Value + Option Premium.
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Stock Option Open Interest & Liquidity
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A critical aspect of option trading is knowing how to avoid buying illiquid stock option contracts.
Notice that every stock option contract is quoted with a Contract Name, Last Price, Bid, Ask, Volume and Open Interest.
Open interest represents the number of open contracts still floating in the exchange for that particular stock option. Open Interest in option trading should not
be confused with Volume as volume represents the number of transactions that took place on that particular option contract.
When an option trader
buys a call option, say, the April44Call represented by the symbol QQQDR, QQQDR's open interest increase by 1. When that option trader sells that
call option contract or exercises that call option contract to close the position, the open interest of QQQDR decreases by 1. Period. It is that simple.
There is a common misunderstanding that open interest represents the liquidity of that stock option contract. That is wrong. In stock trading,
the best measure of liquidity, or how quickly each order gets filled at the price that the trader wants, is by that stock's volume. In option trading
however, volume is not a good measure of liquidity as many out of the money option contracts continue to be very liquid even though volume is very low.
This made many option traders turn to the next unique number, the open interest, as an indication of liquidity. This again is not accurate as every
single option contract started out with 0 open interest when first launched in the exchange and then builds up open interest as more and more option
traders buys that option contract. If 0 open interest means a completely illiquid option contract, how then does option traders build up a
portfolio using that option contract?
In option trading, the only good measure of stock option liquidity is therefore how quickly the
market makers are willing to trade with you in the absence of
another corresponding option trader. When a stock option contract is first launched with 0 open interest, option traders buying that stock option
is really buying them from the market makers and when market makers are confident of quickly hedging their positions with these stock options, they
will narrow down the bid-ask spread of that particular contract but if they are not confident of being able to turn a quick profit from selling you
a particular stock option contract, they will compensate that risk with a wider bid-ask spread.
Hence, the bid-ask spread, which is the difference between the bid price and the ask price, is what will give a good indication of the liquidity
of stock options. In option trading, veterans like us would regard a bid-ask spread of wider than 15% of the ask price as being of a wide bid-ask spread.
Looking back up at the Call Option Chain above, you will see that the option contracts for QQQQ are extremely liquid and comes with
a tight bid-ask spread of about $0.02, which represents a bid-ask spread of about 2.2% in most cases. A liquid option with a tight bid-ask spread would naturally
lead to a higher volume and open interest eventually but it does not mean that a higher open interest or volume represents a more liquid stock option
contract.
Read More About Volume & Open Interest.
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Options involve risk and are not suitable for all investors.
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