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Stock Options

How Do Stock Options Work

Stock options trading refers to trading of contracts to buy (or sell) a stock for a certain price at a certain time in the future. Buyers of stock options have the right to buy the stock at the specified price, although they are not obligated to exercise their option. Sellers of options have the requirement to sell the underlying stock if the buyer of the option wishes to exercise it.

Call Options

A contract to buy is called a 'call option'. The buyer of a call option hopes the price of the underlying stock will increase, allowing him to buy it at less than market value. The seller of the call option anticipates that the price of the stock will not rise, or at least is willing to understand a partial loss of profits made from selling the call option.

For an instance: suppose if an investor buys a call option on IBM with a 'strike price' (the price the stock can be bought) of $2500. The current price of IBM stocks is $40 and the cost of the call is $5. If the price increases above $55 (strike price + cost of call) the buyer could implement his right to buy and make a profit by reselling on the open market. The seller would still gain from the swell in price from $40 to $55 plus the $5 he made by selling the call. If the price remains below $55 the call would not be exercised and the seller would profit by $5 per share and the buyer would lose his $5 per share.

Stock option trading is allowable on select stocks. The stock options (buy/sell) specify the name of the stock, the strike price (the price the stock can be bought or sold at), the expiration date and the premium (the price of the option itself). After the expiration the option cannot be exercised and is insignificant. Options have a value and are aggressively traded. An option to buy Microsoft, for example, is listed like this: MSFT Jan '06 22.50 Call at $2.00

This informs us that an option to buy 1 share of Microsoft at $22.50 before the third Friday in January 2009 can be bought for $2.00. Options generally expire on the third Friday of the specified month, and they are generally traded in lots of 100. To buy this particular option you will likely have to pay $200 (plus brokerage fees).

Put Options

An option to sell a stock is called a 'put option'. Put options provides the holder the right (but not the obligation) to sell a particular stock within a certain time period at a certain price. In this kind of situation the buyer is expecting the price of the stock to drop but does not want to sell outright in case the price rebounds. The seller feels that the price is stable or is willing to get hold of the stock at the low price.

For an instance: An investor is willing to buy a put option on Microsoft with a 'strike price' (the price the stock can be sold) of $35. The current price of Microsoft is $40 and also the cost of the put is $5. If the price drops below $30 (strike price + cost of put) the buyer could exercise his right to sell at a higher price than market. The seller would have to buy the stock at the higher-than-market price although any losses are offset by the $5 he made by selling the put. If the price tends to remain above $30 the put would not be exercised and the seller would profit by $5 per share and the buyer would lose his $5 per share.

Principles of Stock Option Trading :

As can be seen, stock option trading could be used to protect against loss or as an investment opportunity as their own right. They are usually used as part of a stock trading strategy which combines the purchase of stock with the purchase of options. For instance, in a bull (rising) market you could buy stocks and call options and sell put options. This allows you to take full benefit of rising stock prices, the stocks you buy will rise in value, the call options will allow you to buy stock at less than market prices, and if the market drown and the buyer of your put option exercises it, you can pick up additional stocks at low prices. If the buyer does not implement the option, you make money from the sale of the option.

On the contrary, in a bear market, you can sell stocks, sell calls, and buy puts to limit losses and generate profits. Unbalanced markets can use a mixture of puts and calls to maximize profit potential. Stock option trading usually takes place on Exchanges.

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