What is a Stock Option?
A stock option is a contract to buy stock or sell stock at a specific price before a particular time in the future. It is traded on a specific stock and the name of the stock, the price, premium and the expiration date are all detailed. Options are traded on futures and options exchanges including the Chicago Broad Options Exchange (CBOE) and the American Stock Exchange (AMEX). An option cannot be exercised after the expiration date or it is considered of no value. Buyers and sellers of options have different obligations. Sellers must sell the underlying stocks if the buyers wish to exercise it, and conversely buyers have the right to buy stocks at a specified price, but they are not obligated to exercise their options.
When identifying a stock option it is important to understand three terms. The “call” option, the “strike price”, and the “put” option. A call option describes a contract to buy. Call option buyers anticipate a rise in the prices of stocks so that they can pay less than market value. Call option sellers accept partial loss of profits made from selling the call options, or they expect no changes in the prices of stocks. The strike price is the fixed price at which the owner of an option can purchase in the case of a call or sell. In the case of a “put” option, which we will discuss next, the strike price is the fixed price at which the owner of an option can purchase the underlying security or commodity. Additionally, if the stock prices rise above the combined amount of the cost of the call option and the strike price, the buyer can then exercise the right to buy and therefore will make a profit by reselling the stocks on the open market.
When identifying a stock option it is important to also understand what a “put” option is. A put option is an option to sell a stock when options trading. This type of option gives the holder the right to sell a specific stock within a certain period of time, but not the obligation to do so. The seller is willing to purchase the stocks at a low price because he or she feels that the price is established. The buyer expects in this situation an eventual fall in the stock prices, but he or she will reject a direct sale in case the price rebounds. When taking into account the strike price with the put option, if the price goes below the combined strike price and put cost, the buyer can exercise his or her right to sell at a price that is higher than the market price. The seller then buys the stock at the price that is higher than the market price.
Stock options trading is very exciting yet very confusing. The basic definitions above can really confuse new investors, therefore options traders must have a complete understanding of what they are doing through paper trading options, before they even think of investing with real money!
The Candlestick Forum Team
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