Understanding the Different Stock Options
The contracts to buy or to sell a stock at a particular price before a particular time in the future are called stock options. Although the buyers of these options have the right to buy stocks at the specified price, they are not obligated to exercise their options. Sellers of the options, on the other hand, carry the obligation of selling underlying stocks if the buyers wish to exercise it.
“Call option” is the term used to describe a contract to buy. Call option buyers hope for a rise in the prices of underlying stocks so that they can be allowed to pay less than the market value. Call option sellers, on the other hand, either expect no changes in the prices of stocks or accept partial loss of profits made from selling the call options.
An investor buys a call option on IBM with a $50 “strike price,” which is the price the stock can be bought, and the current price of IBM stocks in $40 and the cost of call is $5. If the stock prices rise above the combined amount of the strike price and the cost of call, the buyer can exercise a right to buy and make profit by reselling the stocks on the open market. The seller will also gain from the price increase of $55 from $40 and the sold call at $5. A price that will remain below $55 will not allow the call to be exercised. It will also cause the seller to profit by $5 per share and buyer to lose $5 per share.
Options are traded on specific stocks. The name of the stock, the strike price, the expiration date, and the premium are all detailed. Because an option cannot be exercised after the expiration, it will be considered worthless.
Options, aside from being actively traded, have their own values. An example of an option to buy Microsoft will be something like this: MSFT Jan06 22.50 Call at $2.00. This indicates that an option to buy one share of Microsoft at $22.50 before the third Friday of January 2006 can be bought for $2.00. The expiration of options is usually on the third Friday of the specified month. They are usually traded in lots of 100. Buying this particular option will require an investor to pay $200, excluding brokerage fees.
A “put option” is an option to sell a stock. The holder in this type of option is given the right, but not the obligation, to sell a particular stock at a certain price within a certain period of time. In this situation, the buyer expects an eventual fall in the stock prices but he refuses an outright sale in case of price rebounds. The seller in this option is willing to acquire the stocks at a low price since he feels that the price is stable.
For example, an investor buys a put option on Microsoft with a $35 strike price while the current price of Microsoft is $40 and the cost of the put is %5. If the price falls below the combined amount of the strike price and the put cost, the buyer can exercise his right to sell at a price higher than the market price. The seller will then buy the stock at the price that is higher than the market price. The losses are offset by the $5 gained by selling the put. The put will not be exercised if the price remains above $30. This will cause the seller to profit by $5 per share and the buyer to lose $5 per share.
Stock options, which can be used to protect against loss, can also be used as investment opportunities. They are commonly used as parts of trading strategies that combine the purchase of stocks with the purchase of options.
Stocks and call options can be bought and put options can be sold in a bull market. In a bull market, an investor is allowed to take full advantage of the rising stock prices. Aside from experiencing an increase in the value of bought stocks, the investors can also buy stocks at lower prices via the call options. If the market dips and the put option buyers exercise it, the investors can pick up additional stocks at low prices. If the buyers don’t exercise the option, the investors can still make money from the sale of the option.
In a bear market, however, investors can sell stocks, sell calls, and buy put options to limit their losses and generate their profits. A mixture of puts and calls are used by unstable markets in order to maximize their profit potential. Options are traded on Futures and Options Exchanges. In the US, there are 6 of such exchanges that include the American Stock Exchange (AMEX) and the Chicago Board Options Exchange (CBOE). The main options exchanges in Europe are the Euronext.liffe. and Eurex.