Stock options can be a very complicated and esoteric area to navigate for a first-time user.
Trading stock options platforms, like opening a brokerage account, provide different tools and information to aid the trader in comprehending and making options trades.
This paper tries to de-complicate stock options and center it with a focus on basic components that are important and easily understandable like strike price, expiration dates, and the contract quantity to build the basics for first-timers to begin.
What Are Stock Options?
Stock options are financial derivatives that provide the buyer with the right to buy or sell a stock at a pre-set price within a certain period of time. This makes them a very popular choice for traders who wish to hedge against risks or speculate on future stock movements.
Understanding the Strike Price
One of the important ingredients of an options contract is the strike price. It is defined as the price per share that the underlying stock can be purchased at if the option is a call or sold at if the option is a put, when exercised.
Definition: It is the price agreed upon in the options contract to accomplish the transaction set forth in the options contract.
As long as a buyer buys a call at $100, he has an option to buy the stock, no matter the market price, but at $100.
Importance: The difference between the stock price and its strike price has a determinant bearing on the value of an intrinsic option. These differences determine profits and how the person would ever make a judgment on exercising options.
The Role of Expiration Dates
Option’s expiration dates tell one the specific time frame on whether to either exercise or lapse the option
Time Frame. Options have days, weeks and years as examples of their commonly known expiration days. Some weekly or month, quarterly bases.
Impact on Price: The option premium is changed by the factor time until expiry. Options of higher time expiry usually have relatively high premiums for a longer duration wherein the price of the underlying asset has much greater chances of upward movement.
An option exercised on March 15, with an expiry date of this month, and there are 50 days left to the exercise date, means that the buyer has the right to exercise at any date till such period exists.
Each options contract usually represents 100 shares of the underlying stock.
Standardization: Options are standardized so that one contract represents 100 shares, thereby making trading easy and liquid.
Example: One call option means the right to buy 100 underlying shares at a strike price.
Importance: The magnitude of the number decides that one should have tremendous risk management to handle such a number of contracts as the monetary implication of carrying several contracts becomes quite significant.
Types of Options: Call or Put
Options come in two primary types: call options and put options.
Call Options: These are options that give the holder the right to buy the underlying stock at the strike price. They are usually bought when the trader expects the stock price to increase.
Example: An investor buys a call option for ABC stock with a $100 strike price, expecting the stock to go beyond this price.
Put Options: This gives the right to the holder to sell the underlying stock at the strike price. These are used when a trader feels the price of the stock is expected to fall.
Example: A trader buys a put option on ABC stock for $100, with the expectation that the price of the stock will go down.
What Does It Mean to Be “Long” an Option?
Being “long” an option implies that the trader has bought an option contract and owns it in his portfolio.
Ownership: When an option is bought, then the buyer of the option is said to be long that particular option.
Options for the Holder: The long option holder can exercise three fundamental options:
Exercise the Option: They can exercise the right to buy or sell the underlying stock at the strike price.
Let it Expire: They can opt to let the option expire if it is not worthwhile to exercise it.
Sell the Option: They can sell the option to another trader before the expiration date.
How Expiration Dates Affect Options Pricing
Time expiration significantly affects the option price because of the time decay concept.
Time Decay (Theta): The nearer the expiration date, the lesser the time value, and the higher the chances that the option premium will drop.
Weekly Expirations: Most options are currently offered in weekly expirations, which makes the timing looser yet more accurate.
Strategic Planning: A trader would well know how to buy or sell using the remaining time before the expiration date and the predicted direction of the stock movement.
Example of Trading in Practice
ABC Stock Options Trading
Suppose a trader wants to buy a call option for ABC stock.
Strike Price $100
Expiration Date March 15, which is 50 days from today
Quantity One contract equates to 100 shares
Decision: The trader believes the price of ABC stock will move higher than $100, making a call option potentially profitable.
The trader buys the call option and is long in the contract. He will continue to follow the stock until the expiration date to determine whether to exercise the option, sell it, or let it expire.
Understanding the basics, including strike prices, expiration dates, and even the contract quantity, will keep any successful option trader afloat. Key takeaways that give options traders room for good judgments in the way of decision making and managing their risk can go along way into maximizing on other opportunities presented within the market. Researching these instruments carefully in conjunction with solid planning can definitely yield great successes in trading.
