Candlestick Trading Blog

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Stock options come in two forms: call and put options. Call options afford the buyer the right to purchase the stocks at an agreed strike price any time before the stock option expires. Puts, on the other hand, are stock options that give its buyer the right to sell a stock at an agreed price on or before the expiration date.  In a sense, options are kind of like a calculated bet. The person who buys a stock option (whether it is a call or a put) is speculating on the direction that the price of the stock will take. Someone who believes his or her stock price will drop may buy a put option while someone that thinks a stock price will rise may buy a call option.

Basics Of A Stock Option Contract
There are two basic styles of options contracts: American and European. An American option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style and all stock options are American style. A European option can only be exercised on the expiration date. Many index funds are European style. It is important to know which style contract you have so that you can effectively plan your strategies.

The price of purchasing an option order is called its premium. The buyer of a stock option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security; therefore, the risk to the buyer is never more than the amount of the premium. In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver a call option or taking delivery of a put option. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be hypothetically unlimited and far exceed the option value.

Just a couple more of the basics. The strike price is the agreed amount from the contract. If this amount is negative to the stock option, it is said to be “out of the money”. If it is already positive, it is referred to as “in the money.” An option that has reached the strike price, but is not above or below is said to be “at the money.” These terms become important for planning an investment strategy as well as for determining a cost of a premium. The expiration date also plays a part in the cost of the premium because longer-term contracts have higher premiums since they are more likely to fill. Learning how to invest requires the trader to understand the terms of his or her contract.