Top 6 Fundamentals of Stock Options Trading

Most investors are comfortable dealing with the normal stock market and will happily go about their various buy and sell trades.

However many will baulk when it comes to stock options trading even though this particular investment activity often takes place on the same exchange that they are used to. So why is there this reticence about trading options?

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In short (no pun intended) it comes down to ignorance of exactly what options are all about.

An option is an established financial instrument which goes far beyond stock markets. An option can apply as much to the sale of a property as it can to a stock.

It is simply an agreement or contract between two parties for the future sale of an asset at an agreed price with the underlying provision that the option gives the investor the right to buy (or sell) that asset.

Options are most commonly traded as stocks, currencies, bonds or as a futures contract and for the purpose of this discussion we will assume stocks.

1. What are Call or Put Options?

If the trade is a Call Option then the investor has the right to buy the option and conversely if a Put Option then the investor has the right to sell the option.

As a buyer of options, you do not have to buy (or sell) the asset, but having the right to do so means you can either buy the options, sell the options or just let them expire.

The exact course of action will depend upon the trading circumstances, your investment strategy and a multitude of other considerations, but ultimately the buyer will decide based on what he thinks is best.

2. What is the Option Price?

Options are priced per share but typically are sold in lots of multiple shares. In many markets, these lots are 100 shares although they can also be 1000 shares. So, if  you, the investor, purchase one option, then you are actually buying the right to 100 or 1000 shares.

The price of the option is determined as the difference between the reference price (also called the strike price) and the asset value. A premium may be added depending on the length of time before the option expires – usually the premium decreases as the expiry date approaches.

3. What is the Option Expiry?

An option will always have a time limit attached to it in the form of an expiry date. This can impact the option price as once the the option is exercised (or activated), it can be traded up until the option expiry.

The other consideration to note is if the option is not exercised by the expiration date, the option lapses and has no value.

4. What is Writing the Option?

The company or individual which has issued the option effectively writes the option when a buyer enters into a contract for the option.

At this stage, the issuer takes the option premium paid by the buyer as compensation for carrying the responsibility associated with the option.

Before the expiry date, the buyer may exercise his right to the option. If so, then the writer must deliver in full the asset which is the subject of the option.

5. Considerations When Buying Options in Shares

When you buy options in shares, you only pay the premium attached to the option. This is different to normal share trading where you pay the total value of the stock.

To clarify this, let us assume a stock priced at $40 with a premium of $2, and a lot equivalent to 100 shares. In this case, the investor would pay $200 for one option. If the same shares were to be purchased outright (that is, no options attached), the investor would pay $4,000.

6. What Happens at Option Expiry?

At the end of the contract period, the buyer (investor) can exercise his rights to the option in one of three scenarios with a related responsibility on the writer (seller) of the option:

  • buy the option (a call), in which case the writer must deliver the underlying asset
  • sell the option (a put), in which case the writer must buy the underlying asset
  • do nothing, in which case writer retains the option premium paid by the buyer.

Note that if the buyer decides to either buy or sell (call or put), then the writer of the option must either sell it or buy it (respectively) at the original strike price and not its current market price.

If you want to learn more about stock options trading, here are some recommended books on the subject from Amazon.

To your options trading success!

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