A contract between two parties that gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period, is known as an option contract. While investing in stocks carries a certain level of risk—stock options are particularly risky investments. One contract represents 100 shares of the underlined stock.
The individual selling the stock option is called an option writer, where the buyer pays a premium to the seller for purchasing the contract. There are two types of stock options: A stock call option grants the purchaser the right but not the obligation to buy stock, it increases in value when the underlying stock price rises. A stock put option grants the buyer the right to sell a stock short, it increases in value when the underlying stock price drops.
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How do they work?
The price of a listed option is tied to the price movement of the underlying stock. Where in, if the price of the stock rises or falls, the option will generally move in the same direction. Options usually trade as a contract, unlike stocks.
The bid price is the price that a buyer of the option is willing to pay. The asking price is the price that an option seller is willing to sell the option.
The premium paid by an option buyer or received by an option seller is divided into two parts; both of which affect the option’s premium:
- The intrinsic value is the difference between the strike price of the option and the market price of the underlying stock
- Time is when both when the option expires and the volatility the underlying stock experiences during the period in which the option is held.
Each option also has its own expiration or maturity date. This is the last day on which an option can be exercised into the underlying futures contract. After the expiration or maturity date, the option contract will cease to exist; the buyer cannot exercise and the seller has no obligation.
- Strike Price
They are predetermined prices. Investors can purchase call contracts of XYZ company at the strike price of $208, for example, even though the current market price is $210. Alternatively, they can purchase the call option at a strike price of $213.
In the above example, an option strike price of $208 is called in-the-money, and the strike price of $213 is out-of-the-money. In-the-money options, when exercised, result in a profit, while out-of-the-money options, when exercised, will result in a loss.
The premium is determined by taking the price of the call and multiplying it by the number of contracts bought, then multiplying it by 100. It represents the maximum profit the seller of the option can realize. You can think of selling the option in the same way you’d think about selling shares of a given stock.
- Lot Size
One contract represents 100 shares of the underlined stock.
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Mr. A purchases XYZ, November 2016 call options with a strike price of $508. The option contract premium costs $723 for one contract of 100 shares. XYZ, at the time of purchase, stood at $509.10. If the option exercised, Mr. A would get 100 AAPL shares at $508 the next trading day.
The next day, XYZ opened at $509.20. If Mr. A decided to sell the shares at market price, his profit is ($509.20 – $508)*100 – $723 = -$603 (Each broker has different fees & commission structures hence the calculation does not include commission and transaction fees).
Stock options are designed in a way so that they can be part of an overall financial plan. Owning stock options comes with its own rights and responsibilities regarding compensation and investing. Stock option owners have to be aware of how to exercise their options to make money and don’t have a risk to lose it and avoid suffering any negative consequences of taxes.
Author: Mahek Medh
About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.