What are stock options?

What are Stock Options?

An introduction to Options Trading

An option can simply be described as a derivative instrument or in other words and instrument whose value is dependant on the value of an underlying asset. As the name suggests it give the holder of the instrument the right (or the option) but not the obligation to buy or sell the underlying asset at a pre determined prices on a specific date or during a specific time period. The underlying asset can be pretty much anything such as an equity stock, a commodity such as corn, a currency, interest rates, a bond or an index.

When talking about options the owner of the option is called the holder while the party that is taking on the risk is called the seller or writer of the option. In their most basic form there are two main types of option; calls and puts.

Types of options

A 'Call' option gives the holder the right to buy the underlying asset while a 'Put' option give the right to sell the underlying asset.

'Vanilla options' is a term used to describe the two most basic types of options: European and American. European options are ones that can only be exercised on the expiry date whereas American options can be bought or sold on any business day up to and including the expiry date. As a result the American option provides the holder with more optionally than a European option and as a result will be more expensive.

Types of options

A 'Call' option gives the holder the right to buy the underlying asset while a 'Put' option give the right to sell the underlying asset.

If you had taken this common sense approach and invested in Apple during 2003 when the iPod was first starting to take off you could have picked up the stock for as little as $6.36. The highest the stock reached during 2007 was $202.96. That represents a 3,191% return in just over 4 years which by any means is an incredible return. The point to take away from this example is that simply by keeping your eyes open it is perfectly plausable for you to spot the next big thing or trend and and apply this smart stock investing approach in order to make gains.



Some basic option terminology

The pre determined price at which the underlying assets can be bought or sold is called the 'strike price' or 'exercise price' while the date of sale is known as the “expiry date” or “exercise date”.

The Option Premium

The premium of an option is simply the amount paid by the buyer of the option for the right to have the option to execute the trade in the underlying asset. The premium is paid upfront and effectively compensates the seller of the option for the risk he or she is taking on by granting the option to the buyer.

The premium of an option is often thought of in much the same way as an insurance premium. The buyer is looking for someone to relieve them of some form of risk, the seller will have made some form of statistical measure of the risk and quoted a fee that will adequately compensate him for taking on that risk.