Options education is very important. Options are financial instruments that can provide you with flexibility in almost any investment situation you might encounter. Options trading education is critical, as strategies can be very complex. One doesn’t necessarily have to take an options trading course to become familiar with the nuances of these instruments commonly referred to as ‘derivatives’. Take some time to become familiar with the option education below.
Options are financial instruments that can provide you with the flexibility you
need in almost any investment situation you might encounter. Options give you options
by giving you the ability to tailor your position to your own situation.
- You can protect stock holdings from a decline in market price.
- You can increase income against current stock holdings.
- You can prepare to buy stock at a lower price.
- You can position yourself for a big market move - even when you don't know which
way prices will move.
- You can benefit from a stock price's rise or fall without incurring the cost of
buying the stock outright.
The following information provides the basic terms and descriptions that any investor
should know as they learn about equity options.
- An equity option is a contract which conveys to its holder the right, but not the
obligation, to buy (in the case of a call) or sell (in the case of a put) shares
of the underlying security at a specified price (the strike price) on or before
a given date (expiration day). After this given date, the option ceases to exist.
The seller of an option is, in turn, obligated to sell (in the case of a call) or
buy (in the case of a put) the shares to (or from) the buyer of the option at the
specified price upon the buyer's request.
- Equity option contracts usually represent 100 shares of the underlying stock.
- Strike prices (or exercise prices) are the stated price per share for which the
underlying security may be purchased (in the case of a call) or sold (in the case
of a put) by the option holder upon exercise of the option contract. The strike
price, a fixed specification of an option contract, should not be confused with
the premium, the price at which the contract trades, which fluctuates daily.
- Equity option strike prices are listed in increments of 1, 2 ½, 5, or 10 points,
depending on their price level.
- Adjustments to an equity option contract's size and/or strike price may be made
to account for stock splits or mergers.
- Generally, at any given time a particular equity option can be bought with one of
four expiration dates.
- Equity option holders do not enjoy the rights due stockholders - e.g., voting rights,
regular cash or special dividends, etc. A call holder must exercise the option and
take ownership of underlying shares to be eligible for these rights.
- Buyers and sellers in the exchange markets, where all trading is conducted in the
competitive manner of an auction market, set option prices.
The two types of equity options are Calls and Puts.
Right to Buy
Obligation to sell
Right to sell
Obligation to buy
The opposite of a call option is a put option, which gives its holder the right
to sell 100 shares of the underlying security at the strike price, anytime prior
to the options expiration date. The writer (or seller) of the option has the obligation
to buy the shares.
An option's price is called the "premium." The potential loss for the holder of
an option is limited to the initial premium paid for the contract. The writer on
the other hand has unlimited potential loss that is somewhat offset by the initial
premium received for the contract. Investors can use put and call option contracts
to take a position in a market using limited capital. The initial investment would
be limited to the price of the premium.
Investors can also use put and call option contracts to actively hedge against market
risk. A put may be purchased as insurance to protect a stock holding against an
unfavorable market move while the investor still maintains stock ownership. A call
option on an individual stock issue may be sold, providing a limited degree of downside
protection in exchange for limited upside potential.
The security - such as XYZ Corporation - an option writer must deliver (in the case
of call) or purchase (in the case of a put) upon assignment of an exercise notice
by an option contract holder.
The Expiration day for equity options is the Saturday following the third Friday
of the month. Therefore, the third Friday of the month is the last trading day for
all expiring equity options.
This day is called "Expiration Friday." If the third Friday of the month is an exchange
holiday, the last trading day is the Thursday immediately proceeding this exchange
After the option's expiration date, the contract will cease to exist. At that point
the owner of the option who does not exercise the contract has no "right" and the
seller has no "obligations" as previously conveyed by the contract.