Investment Tips

Basics of stock option


A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy or sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.

The terms specified in an option contract include:

Option Type
The two types of stock options are puts and calls. Call options gives the buyer the right to buy the underlying stock while put options give him sell rights.

Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It is relation to the market value of the underlying asset affects the moneyness of the option and majorly determines the option’s premium.

In exchange for the rights conferred by the option, the option buyer has to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, and the time remaining for expiration.

Date of Expiration
Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option.

Option Style
The manner in which options can be exercised also depends on the style of the option and an option contract can be American or European style. American style options can be exercised any time before expiration whereas European style options can only be exercised on expiration date itself. All of the stock options presently traded in the marketplaces are American-style options.

Underlying Asset
The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder when the option is to be exercised. In the case of stock options, the underlying asset refers to the shares of a particular company. Options are also available for other types of securities such as currencies, indices and commodities.

Contract Multiplier
The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event of option exercise. For stock options, each contract covers 100 shares.

The Options Market
Participants in the options market buy and sell call and put options. Those who buy options are known as holders whereas sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.


The author Paul