A stock option is a legal contract between two parties who agree to trade a fixed number of shares with each other at a fixed price within a fixed timeframe. Like shares, options are traded on stock exchanges and are available through online stock brokers.
The obligations of the option buyer and seller are different.
The option buyer has the right to buy or sell shares at the specified price, within the specified time frame, but he or she need not exercise this right.
The option seller – often called the option writer – is legally obliged to fulfill the contract if the buyer chooses to exercise the option, which they will do if the contract is in profit.
The most basic attraction of options is leverage. The percentage movement in an option price is much higher than the percentage movement in the underlying share price.
Options are a type of financial derivative. This means their price is based on the price of an underlying asset. In the case of stock options, the underlying asset is shares. Options differ from their underlying assets in that they have an expiry date. The expiry date also helps determine the price of an option. The longer the time to the expiry date, the higher the price of an option – the buyer pays extra for additional time in which the underlying asset can reach a price that makes him or her a profit – or in traders’ jargon, until the option is in-the-money.
Option buyers’ potential profits are unlimited but, since they do not need to exercise the option, their loss is limited to the initial cost of the option. Option sellers must be more cautious. Writing naked options carries considerable risks.
There are two types of option – call options and put options.
A call option gives its buyer the right to buy shares at the strike price. The person who writes the option is legally obliged to sell stock to the option buyer if he or she requests it.
A put option gives its buyer the right to sell shares at the strike price. The person who writes the option is legally obliged to buy stock from the option buyer if he or she requests it.
In fact, shares do not need to change hands. If the option buyer is in-the-money when the option expires, they are generally paid their winnings in cash rather than via a delivery of shares.
A Stock Option Example
Suppose that shares of stock XYZ trade for $10, and a trader with $1,000 believes that in six months the stock price will double to $20.
He could buy 100 XYZ shares with his $1,000, and sell them in six months for $2,000, yielding a $1,000 profit.
Alternatively, an option to buy an XYZ share for $10 in six months time costs $2. Our trader could buy 500 XYZ options with his $1,000.
In six months time, if the trade turns out as he hopes, his options will give him the right to buy 500 shares for $10 when their price has risen to $20.
He could therefore sell 500 XYZ shares for $20 each, receiving $10,000. His profit (disregarding fees) would be $9,000 (the sale price of the shares minus the premium paid for the options) compared with a profit of $1,000 if he had traded the underlying shares.
If he were wrong and XYZ stock fell to $7, his options would expire with zero value and he would have lost the entire $1,000 premium he paid for the options compared with a loss of $300 if he had traded the underlying shares.
Costly common mistakes investors make – Speculating too heavily in options or futures because you see them as a way to get rich quick… Some investors also focus mainly on shorter-term, lower-priced options that involve greater volatililty and risk. The limited time period works against holders of short-term options.
William J. O’Niel, How to Make Money in Stocks
Macro trading is all about timing. We all know stuff is going to move, but we’re not exactly sure when. Options are the easiest way of controlling risk while affording a good return.
Interview with Currency Fund Manager, Steven Drobny, Inside the House of Money