Stock Option

An option, but not obligation, to buy or sell stocks

What is Stock Option?

A stock option is a contract between two parties which 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 could be called an underwriter, where the seller is paid a premium from the contract purchased by the stock option buyer.

 

Stock Option Type

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. A put option will increase in value when the underlying stock price drops.

Investment bankers may purchase these two options exclusively, or in conjunction with each other to apply certain trading techniques, such as a covered call.

 

Strike Price

Stock options come with a pre-determined price, called a strike price. investors can purchase call AAPL contracts at the strike price of $108, even though the current market price is $110. Alternatively, they can purchase the call option at a strike price of $113. The difference between strike price and current market price will be the premium paid for the option purchased.

In the above example, an option strike price of $108 is called in the money and strike price $113 is out of the money. in the money options, when exercised, must result in profit, while out the money options, when exercised, will result in a loss.

 

Settlement / Expiration

Each option has a different expiration and rule for settlement. There are two option styles present.

  • 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 exercise at the expiration date.

In the past, when the holder of option exercise his right, the transaction will proceed and deliver the certificate of stocks to the holder. In the modern market, all settlements occur in cash.

 

Example of Option Transaction

Mr. A purchases AAPL November 2016 call options with strike price of $108. the contract priced each share at $2.23 and costs $223 for one contract of 100 shares. AAPL, at the time of purchase, stood at $109.10. If the option exercised, A would get 100 AAPL shares at $108 the next trading day.

Next day, AAPL opened at $109.20. If 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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