What is a Stock Option?
A stock option is a contract between two parties that gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period.
A seller of the stock option is called an option writer, where the seller is paid a premium from the contract purchased by the buyer.
Stock Option Types
There are two types of stock options:
- A stock call option, which grants the purchaser the right but not the obligation to buy stock. A call option will increase in value when the underlying stock price rises.
- A stock put option, which grants the buyer the right to sell stock short. A put option will increase in value when the underlying stock price drops.
Investment bankers may purchase either of these two types of options individually or in conjunction with each other to apply certain trading techniques, such as a covered call.
Stock options come with a pre-determined price, called a strike price. Investors can purchase call AAPL contracts at the strike price of $108, for example, even though the current market price is $110. Alternatively, they can purchase the call option at a strike price of $113.
In the above example, an option strike price of $108 is called in-the-money, and the strike price $113 is out-of-the-money. In-the-money options, when exercised, result in a profit, while out-of-the-money options, when exercised, will result in a loss.
Each option has a different expiration date and rule for settlement. There are two option styles in the markets.
- An American-style option which allows the holder of the option to exercise the call/put option any time before expiration
- A European-style option which only allows the option to be exercised on the expiration date.
In the past, when the holder of an option exercised his right, the transaction was processed and the certificates of stocks delivered to the holder. In the modern market, all settlements occur in cash, based on the value of the underlying stock.
Mr. A purchases AAPL November 2016 call options with a strike price of $108. The option contract premium costs $223 for one contract of 100 shares. AAPL, at the time of purchase, stood at $109.10. If the option exercised, Mr. A would get 100 AAPL shares at $108 the next trading day.
The next day, AAPL opened at $109.20. If Mr. A decided to sell the shares at market price, his profit is ($109.20 – $108)*100 – $223 = -$103 (This calculation does not account for commission and transaction fees; each broker might have different fees & commission structures).
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