Stock Options Definition
A stock option is a financial instrument that gives its holder the right but not the obligation to buy or sell a security for a set price on or before a set date. Stock options are traded on financial bonuses. A stock option contract typically consists of no less than 100 options. A trader can enter into a stock option contract to profit from or protect against volatility in the underlying security without actually having to invest in the underlying security. A stock option is exercised when the stock option holder decides to buy or sell the underlying security. If a stock option is not exercised by its expiration date, the stock option expires.
A stock option contract has an option premium, a strike price, and an expiration date. The option premium is the price of the stock option contract. The strike price refers to the price of the underlying security at which the stock option can be exercised. The expiration date is the date on which the option contract expires.
There are two basic types of options: calls and puts. A call option gives its holder the right to buy the underlying security. A put option gives its holder the right to sell the underlying security.
Call Option Contract
A call option gives its holder the right to buy the underlying security at a set price on or before a set date. If a trader expects a security to rise in value, the trader can buy a call option on that security.
Put Options Contract
A put option gives its holder the right to sell the underlying security at a set price on or before a set date. If a trader expects a security to fall in value, the trader can buy a put option on that security.
Stock Options Examples
Call Option Example
A stock is currently trading at $10. A trader expects the stock to rise in value so he buys a call option. The premium is $1, the strike is $12, and the option expires in 1 month. For the option to make a profit, the stock must rise above $13 before the contract expires. Let’s say the stock rises to $15 within a month. The trader can then exercise the option and make $2 profit. He buys the stock at $12 when it is worth $15, so he gains $3. But the cost of the option was $1, so his profit is $2.
Put Option Example
A stock is currently trading at $10. A trader expects the stock to fall in value so he buys a put option. The premium is $1, the strike is $8, and the option expires in 1 month. For the option to make a profit, the stock must fall below $7 before the contract expires. Let’s say the stock falls to $5 within a month. The trader can then exercise the option and make $2 profit. He sells the stock at $8 when it is worth $5, so he gains $3. But the cost of the option was $1, so his profit is $2.
Black Scholes Model
The value of an option consists of time value and intrinsic value. Option values can be determined using the Black-Scholes formula, or other option valuing formulas.
European Options vs American Options
American options can be exercised at any time during the life of the option contract. You can only exercise European options on the expiration date. Both types of contract trade in markets all over the world.
In-the-Money Call Option
An option is in-the-money if exercising it immediately would result in a profit.
At-the-Money Call Option
An option is at-the-money if exercising it immediately would result in no profit or loss.
Out-of-the-Money Call Option
An option is out-of-the money if exercising it immediately would result in a loss. (A trader would not exercise an out-of-the money option, but instead would simply let it expire.)
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See Also:
Intrinsic Value – Stock Options
Initial Public Offering (IPO)
Black Scholes Option Calculation
Binomial Options Pricing Model
Subscription (Preemptive) Rights
