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Stock Options - Definition
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.
p/s : Are you looking for Employee Stock Options?
Stock Options - Introduction
Stock options are one of the most creative, innovative and flexible financial derivative instrument that has ever been created. It has found it's place not only in the stock markets but also as employee benefits in order to participate in a company's growth. Learning about what stock options are is a must for anyone who wishes to participate in options trading. This tutorial shall provide a free, indepth look into what stock options are, the different types of stock options, how they work and much more, written in layman terms and explained with pictures.
Stock Options Tutorial Content
What Are Stock Options? | Call & Put Stock Options | Stock Options Contract Specifications | Parties In Stock Options Transactions | Types Of Stock Options | Styles Of Stock Options | Benefits Of Trading Stock Options | Risks Of Stock Options | Stock Options Pricing | Profiting From Stock Options | Stock Options Markets | History Of Stock Options
What Are Stock Options?
Since the early 70s, stock options have become one of the most important derivative instrument besides stock futures (Read about the Differences Between Futures And Options). Stock Options are simple contracts that allow the owners to buy or sell a stock at a specific price before it expires, yet, that simplicity has made Stock Options one of the most versatile speculative and hedging instrument ever created, elevating options trading to its current level of importance.
Lately, gurus such as Robert Kiyosaki has popularized the use of Stock Options and Options Trading as a way of investing for greater rewards for little risk. So, what exactly are Stock Options?
If you have ever purchased a home, you would have signed something called an "Option To Purchase". That "Option To Purchase" makes sure that the seller of that house makes it available for sale the moment you decide to exercise that option at the price agreed in the option.
That is exactly the same when you purchase Stock Options.
The seller of the Stock Options is obligated to sell you the underlying stocks at the price agreed in the Stock Options contract the moment you decide to exercise that option. Such Stock Options are known as Call Options. Stock Options which allows you to SELL your current shares at an agreed price in the future are known as Put Options.
Call & Put Stock Options
If you own Call Options, which are Stock Options contracts allowing you to buy the stock in future at the current agreed price, and the stock rallies strongly, that call option becomes more and more valuable due to the fact that you are able to still buy it at the lower agreed price from the seller of the Stock Options if you should exercise the Stock Options.
Stock Options Trading is exactly like 2 persons betting against each other. The person who speculates that the price of the stock is going to do badly would sell Call Stock Options to the other person who speculates that the price of the stock is going to go up. If the stock drops, the seller of the call stock options, known as the "writer", wins and gets to pocket the money the buyer paid for the Stock Options. If the stock rises, the seller of the call stock options is obligated to still buy the stocks at the lower price from the buyer, known as the "holder", and loses money.
Read The Full Tutorial On Call Options.
Conversely, if you own Put Options, which are Stock Options contracts allowing you to SELL your current stocks in future at the current agreed price, and the stock ditches, that put option becomes more and more valuable due to the fact that you are still able to sell your stock at the higher agreed price to the seller of the put stock options!
In this case, the seller of the put options is speculating that the price of the stock would go up while the buyer of the put options is speculating that the price of the stock would go down. If the stock rises, the buyer of the put options would obviously not exercise the put option's rights to sell his stocks at the lower price and would just let the put stock options expire, allowing the seller of the put options to pocket the money paid by the buyer for those stock options. If the stock falls, the buyer of the put options would still be able to sell the stocks to the seller at the higher price agreed, making a profit out of the seller.
In a nutshell, the buyer of call stock options profits when the stock goes up and the buyer of put stock options profits when the stock goes down. Conversely, the seller of call stock options profits when the stock goes down and the seller of put stock options profits when the stock goes up.
Read The Full Tutorial On Put Options.
Lot Size: The number of shares of the underlying stock that is represented with each stock options contract. In the US market, each Stock Options contract usually represents 100 shares of the underlying stock.
Type Of Option: Whether it is a call option or a put option.
Terms Of Delivery: Call option sellers must sell and deliver the underlying stock to the buyer if exercised and put option sellers must buy the underlying stock from the buyer if exercise by cash.
Parties In Stock Options Transactions
There are basically 2 parties to a Stock Options transaction. A buyer and a seller. Any individual can be a buyer or a seller of call or put stock options through the various stock options exchanges. You could buy a call option and you could also sell a call option if you want to. So, who is this other party you are trading with? When you trade exchange traded stock options, you are in fact trading with a professional institution or individual known as Market Makers. Market makers buy from you when you want to sell and sell to you when you want to buy. Market makers essentially guarantees liquidity in the stock options trading market.
Types Of Stock Options
Stock Options are traded in several forms:
Exchange Traded Stock Options: These are Stock Options which anyone can trade with in the public stock options trading exchanges through a broker. They are also known as "Listed Options".
Over-The-Counter (OTC) Stock Options: These are Stock Options which are highly customized and traded in Over-The-Counter (OTC) markets which are less liquid and less assessible to the public.
Exotic Options: Exotic options are Stock Options that are highly customized and complex and usually traded only in OTC markets. Read all about Exotic Options.
Employee Stock Options: Stock Options given to employees by their companies. The company in this case acts as the seller of the stock options to employees and usually gives these Employee Stock Options as incentives. Read all about Employee Stock Options.
Stock options can also be classified by their expiration cycles.
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.
Quarterly Options : Introduced in 2006, these are options that expire at the end of every quarter and could co-exist with regular options with the same expiration month. Read more about Quarterly Options.
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.
Read the tutorial on Options Distinguished By Their Expiration Cycle.
Benefits Of Trading Stock Options
So, why trade Stock Options when you can also profit from both upwards and downwards move through buying and shorting shares? Why trade Stock Options when you can trade stock futures for even greater leverage? There are 3 important reasons why Stock Options are better than just trading stocks or futures and they are Leverage, Protection and Flexibility.
Leverage Of Stock Options
As Stock Options cost only a small fraction of the price of the underlying stock while representing the same amount of shares, it allows anyone to control the profits on the same amount of shares with a much smaller amount of money. With the same amount of money that you would have spent on buying shares, that same amount of money would allow you to control a much bigger amount of that stock through buying its Stock Options. The power to control more shares with lesser money produces leverage.
Being able to control more shares with the same amount of money also means that profitability is far greater trading Stock Options on the same amount of money relative to trading stocks.
As you can see from the example above, buying call options would produce 20 times more profits than buying shares, which means that buying call options in this case produces 20 times the leverage of buying stocks!
Learn how to trade call options properly through the Long Call Options strategy.
On top of that, Stock Options leverage or "gearing" can be precisely calculated and variable as the Options Moneyness changes. Typically, In The Money Options produce less leverage while Out Of The Money Options produce more leverage.
Due to the variable nature of Stock Options leverage, many different trading styles can be applied successfully using Stock Options. Long term options trading strategy would employ lesser leverage while day trading strategies would employ greater leverage.
Stock Options leverage also allows investors with a small amount of money to control significant amount of shares of companies which would be otherwise too expensive to own. Read all about Options Leverage.
Protection Of Stock Options
Buying Stock Options is like buying insurance. Buying a put option allows you to always be able to sell your stocks at the strike price no matter how low the stock falls to. This is known as a Protective Put. Indeed, Stock Options started out as a hedging instrument more than a speculative instrument. Stock Options allows stock traders to hedge away directional risk anytime they want to, conveniently and without margin implications.
Furthermore, as Stock Options allows you to control the same amount of shares at a much lesser price, you can risk lesser capital on every trade using Stock Options, thus reducing capital exposure to risk. Unlike futures, Stock Options have no margin requirement and the maximum loss is limited to the amount of money paid on the Stock Options contracts. One such method of utilizing call options is known as the Fiduciary Call.
Flexibility Of Stock Options
Stock options grants stock and option traders the flexibility to change from one market opinion to another without significantly changing your current holdings through the use of Synthetic Positions and Synthetic Options Strategies. Yes, you can structure a position to profit even if the stocks you are holding falls!
In fact, stock options can sometimes be safer than just trading stocks! Read about How Stocks Is Riskier Than Options.
Risks of Stock Options
The single most significant risk of Stock Options is definitely the fact that if it expires out of the money, the stock options contract expires worthless and you lose all the money you put into buying that stock options contract. If you put all your money into a single stock options contract and it expires out of the money, you will lose all your money. That is why understanding Options Moneyness and having a sensible trade management strategy is so important in options trading.
The second most significant risk in Stock Options Trading is known as " Time Decay". Stock Options contracts are sold for a price, a kind of compensation to the seller for taking the extra risk. However, as Stock Options contracts draw nearer to expiration, the risk to seller reduces and the value of the stock options diminshes. What this means in options trading is that if you bought a call option and the stock don't rally fast enough, time decay will take back so much of the value that the call options may not be profitable even if the stock went up. Fortunately, time decay can be measured through the options greeks so that they can be hedged away.
There are many more risks to Stock Options Trading that are more technical in nature. Please read more about Options Trading Risks.
How Are Stock Options Priced?
Stock Options contracts consists of 2 main price components, the Intrinsic Value and the Extrinsic Value. In a nutshell, Intrinsic value is the portion of the underlying stock's value that is already built into the stock options contract. Call options have intrinsic value when the stock moves up, building value into the call option which has the right to still buy at the lower price. Put options have intrinsic value when the stock moves down, building value into the put option which has the right to still sell at the higher price. Intrinsic value is therefore pretty straight forward and is the main component of profiting from stock options trading.
Extrinsic value is the tricky bit. Like insurance, Stock options contracts comes with a price to own whether or not they get exercised. This price is a way of compensating the seller of stock options for taking the extra risk. This price, or Extrinsic Value, and how to price it properly still baffles the finance world today. The question is, how much should sellers of stock options be compensated in the prevailing circumstances? Many factors come into play and the most popular stock options pricing model is no doubt the Black-Scholes Model. As stock options consist only of the extrinsic value, which is frequently just a few cents, and a small fraction of the price of the underlying stock in intrinsic value, if any, stock options costs only a fraction of the price of the underlying stock, creating financial leverage.
Options Traders who hold each stock options contract to expiration usually do not bother too much with how extrinsic value is calculated and whether or not they are getting a good deal. These Stock Options Traders simply take the price they pay on the stock options as an expense , just like an insurance premium, and aim to buy stock options on stocks that are likely to move more than the price paid on them.
How Do We Profit From Stock Options?
In a nutshell, options traders profit from Stock Options trading through 2 main avenues; From a move in the underlying stock or time decay through selling stock options. Profiting from a move in the underlying stock is probably the most popular way of profiting in stock options trading. options traders who buy call options wants to profit from the build up in intrinsic value as the stock goes higher and higher. Conversely, options traders who buy put options wants to profit from the build up in intrinsic value as the stock goes lower and lower.
There are also options traders who would rather "play the bookie" and become writers or sellers of stock options. When you sell stock options, you receive the extrinsic value or price of the options as compensation for taking on that extra risk. When the opinion of the buyer of those stock options is wrong, you get to pocket the price of the options as profits.
There are, in fact, ways to profit using stock options for every move in the underlying stock and are collectively known as Options Strategies. We have a list of all options strategies here in our Options Strategy Library.
Where Are Stock Options Traded? - Stock Options Markets
Like stocks, Stock Options are publicly traded in marketplaces called "Exchanges". In the US, stock options are traded in 5 main Stock Options Exchanges, namely:
American Stock Exchange (AMEX)
Chicago Board Of Options Exchange (CBOE)
International Securities Exchange (ISE)
Pacific Exchange (PCX)
Philadelphia Stock Exchange (PHLX)
Options Traders buy and sell stock options through their option trading brokers who will in turn place and fill these orders with market makers in any of these 5 stock options exchanges. The decision of choosing which market maker to deal with in these 5 stock options exchanges are usually made for you by your broker but for options traders who wish to deal directly with specific brokers, Level 2 Quotes are also available by most brokers.
Brief History Of Stock Options
Options contracts goes a long way back to about 332 B.C. where it was used to secure the rights to use olive presses as well as back in the tulip mania of 1636 in Europe. The first real stock options were created back in 1872 by American Financier Russell Sage who invented the first call and put options to be traded in Over The Counter (OTC) markets. Yes, stock options were first traded as unstandardized contracts which has no standard pricing model nor terms. Sellers simply charged a price they felt was reasonable, resulting in very inefficient markets.
With the creation of the Chicago Board Of Options Exchange (CBOE), which is still the biggest stock options exchange in the world today, in 1973 and the invention of the Black-Scholes Option Pricing Model in the same year, call and put options are at last standardized and accessible to the general public. For the first time, any member of the public may buy and sell stock options. The Options Clearing Corporation or OCC, was then created as a guarantor for all stock options contracts, guaranteeing the performance and delivery of every stock options contract. This combination created the modern, standardized and highly efficient options trading market that we have today.
By 1976, the American Stock Exchange, Philadelphia Stock Exchange as well as the Pacific Exchange also begun trading stock options as demand for stock options increased exponentially.
Read the complete tutorial on the History of Options trading.