A stock option, however, is more than just a contract. Read this stock options explained guide and learn from the insights we’ll share. We’ll also discuss the main types of stock options, and even give you tips on how to start stock options trading.
What are Stock Options?
In a nutshell, stock options are contracts that involve two parties. The most common type includes a business and an employee. Under the contract, an individual has the right but under no obligation to buy and sell stocks at a pre-determined price. So, owners of options stocks can buy or sell underlying stocks.
Basically, you’ll buy stock options at a price known as the premium. At the same time, you’re buying rights that come with the option. More so, these options also come with an expiration date. Hence, you must use the option before the said date.
It’s also important to understand what an option is. Simply put, it’s a type of financial instrument called a derivative. The value depends on the price of an underlying asset. Therefore, in stock options, the value of the options relies on the stock shares.
Options Stocks Parameters
For a better understanding of stock options, it helps to look at their parameters. Essentially, there are four important things you must know.
It’s the price you’ll pay for an option. More so, this is the current market price, and hence, reflects the income that the seller receives from a trade. The premium is expressed as dollars per share.
Stock options aren’t forever. They’re available only up to a certain period, which is known as the expiration date. The date is based on a fixed schedule, which is also called the options cycle. It can range from daily to a year.
It represents the number of underlying shares a trader may purchase. One contract translates to 100 shares of an underlying stock.
The strike price refers to what the trader expects on the price of the stock, whether it will be above or below before the expiration date.
How to Trade Stock Options
The first thing to do is to open an options trading account. Choose a reliable platform that offers a user-friendly interface.
Further, there are four things that you can often do with your options stocks:
- Buy calls
- Sell calls
- Buy puts
- Sell puts
Those who buy options are holders. On the other hand, those who sell are writers.
Example of Options Stocks
To understand how do stock options work, let’s look at an example.
Let’s say Company X has a current market price of $30. Meanwhile, the stock option’s strike price is $40. On the other hand, the premium is $10. The market value on expiry is $20 and $50. The contract size is 100 shares.
From the above example, a market value of $20 on expiry means it’s below the current market price. It translates to a loss. Meanwhile, if the market value on the expiration date is $50, it’s higher than the strike price. In turn, the trader can exercise the option stocks.
What are the 2 Main Types of Options Stocks?
The first main type of stock option is a call option. Under the latter, the buyer has the right but no obligation for purchasing stock. As the underlying stock price increases, the value of a call option also goes up.
Meanwhile, the second type is a put option. It gives the buyer the right for selling short stocks. A drop in the underlying stock price translates to an increase in the value of a put option.