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Introduction To Stock Options

Introduction To Stock Options

Introduction To Stock Options

By: PromptTrader

A stock option is an investment tool that represents a contract between a buyer and a seller.  Specifically, an option is a contract that gives the owner the right, but not the obligation, to buy or sell a given stock at a specified price on or before a specified date.  Options also exist for future contracts, foreign exchanges and other instruments. However, this article will focus solely on stock options.  The majority of options trade on the CBOE (Chicago Board Option Exchanges) and not at the New York Stock Exchange or Nasdaq exchange.  Currently, the CBOE offers options on roughly 2,200 companies, 22 stock indexes, and 140 ETFs (exchange traded funds).

There are two different kinds of options: call options and put options.

Call Options

The buyer of a call option has the right, but not the obligation, to buy from the seller a specified stock at a specified price on or before a specified date.  The buyer of the contract pays a fee (known as a premium) to the seller of the contract for this right.  In return the seller of the contract is obligated to sell the stock should the buyer decide to exercise his right.  Since options are traded in an open market, a holder of a call option can elect to sell the option to someone else.  Each option is organized in a “chain” and provides the investor with all the necessary information.  An example of an option chain that can be found on Yahoo Finance is: RIMM130125C00015000 0.62

The first 4 letters represent the stock whose option is being traded.  In this example RIMM is the ticker for Research In Motion.

The first two numbers “13” represents the year in which the option expire.

The next two numbers “01” represents the month in which the option expire.

The next two numbers “25” represents the day in which the option expire.

The next letter “C” indicates that this is a call option.

The following numbers represent the strike price of $15.00 (note that option chains include 3 decimal points).

The following number “0.62” represents the price of purchasing one contract.

An investor who purchases this option is purchasing the right (but not the obligation) to buy 100 shares of RIMM at $15 (strike price) on or before January 25, 2013 (expiration date).  Call options can only be purchased in lots of 100, therefore an investor can buy 1 lot for $62.  The $62 is paid to the seller of the option contract and this fee is known as the “premium”.  The seller is obligated to sell the buyer 100 shares of RIMM at $15 regardless of the current price of the stock if the buyer elects to exercise his right.

After the investor purchases the option there are two scenarios that can occur:

  1. The stock is trading at a price above the strike price.  When this occurs the option is considered to be “in the money” because it is earning a profit.  Suppose RIMM is trading at $16, the investor can choose to exercise his option and purchase the stock at $15.  Immediately the investor is realizing a profit of $1 a share or $100 in total.  Taking in to account the premium of $62 the investor is currently profiting $38.
  2. The stock is trading at a price below the strike price.  When this occurs the option is considered to be “out of the money” because it is likely losing money.  Suppose RIMM is trading at $14, the investor will be foolish to exercise his option at $15.  As the expiration approaches the value of the option will continue decreasing until the option reaches a price of $0.00 on expiration date.

 

Put Options

The buyer of a put option has the right, but not the obligation, to sell a specified stock at a specified price on or before a specified date.  The buyer of the contract pays a fee (known as a premium) to the seller of the contract for this right.  In return the seller of the contract is obligated to buy the stock should the buyer decide to exercise his right.  Each option is organized in a “chain” and provides the investor with all the necessary information.  An example of an option chain that can be found on Yahoo Finance is: RIMM130119P00014000 0.13

The first 4 letters represent the stock whose option is being traded.  In this example RIMM is the ticker for Research In Motion.

The first two numbers “13” represents the year in which the option expire.

The next two numbers “01” represents the month in which the option expire.

The next two numbers “19” represents the day in which the option expire.

The next letter “P” indicates that this is a put option.

The following numbers represent the strike price of $14.00 (note that option chains include 3 decimal points).

The following number “0.13” represents the price of purchasing one contract.

An investor who purchases this option is purchasing the right (but not the obligation) to sell 100 shares of RIMM at $14 (strike price) on or before January 19, 2013 (expiration date).  Put options can only be purchased in lots of 100, therefore an investor can buy 1 lot for $13.  The $13 is paid to the seller of the option contract and this fee is known as the “premium”.  The seller is obligated to buy 100 shares of RIMM at $14 regardless of the current price of the stock.

After the investor purchases the option there are two scenarios that can occur:

  1. The stock is trading at a price below the strike price.  When this occurs the option is considered to be “in the money” because it is earning a profit for the investor.  Suppose RIMM is trading at $13, the investor will chose to exercise his right and sell 100 shares at $14 which is a full $1 above the current market price representing a total profit of $100.  Factoring in the premium paid of $13 in this scenario the investor would generate a profit of $87.
  2. The stock is trading at a price above the strike price.  When this occurs the option is considered to be “out of the money” because it is not generating a profit. Suppose RIMM is trading at $15, the investor would be foolish to exercise his option at $14 when he can do so in the market at $15.

Conclusion

The buyer of an option contract can under no circumstance lose more than his initial investment.  If the option is trading at $0.00 the investor would realize a 100% loss, while the seller of the contract would earn the complete premium as profit since the buyer won’t choose to exercise.  The seller of the option can have infinite loss as they can be obligated to buy or sell a stock at a price that is substantially more or less than the current market value.  Investors wanting to trade options can be subject to certain verifications from the broker, as these products are considered to be “risky” and complex.  An investor who wants to sell options will be subject to a very thorough and strict review from the broker as the losses can be infinite.  Options trading is reserved for sophisticated investors and not recommended for beginners.

 

About the author: Jayson Derrick is the director of trading at PromptTrader, an international proprietary trading firm that trades in US equities and options. 

 

 

 

 

 

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