Stock Options
Stock options are contracts to buy (or
sell) a stock at a certain price before a certain time in the future.
Buyers of options have the right to buy the stock at the specified price,
but they are not obligated to exercise their option. Sellers of options
have the obligation to sell the underlying stock if the buyer of the
option wishes to exercise it.
A contract to buy is called a 'call option'. The
buyer of a call option hopes the price of the underlying stock will
rise, allowing him to buy it at less than market value. The seller of
the call option expects that the price of the stock will not rise, or
at least is willing to accept a partial loss of profits made from selling
the call option.
For example: An investor buys a call option on IBM
with a 'strike price' (the price the stock can be bought) of $50. The
current price of IBM stocks is $40 and the cost of the call is $5. If
the price rises above $55 (strike price + cost of call) the buyer could
exercise his right to buy and make a profit by reselling on the open
market. The seller would still gain from the increase in price from
$40 to $55 plus the $5 he made by selling the call. If the price remains
below $55 the call would not be exercised and the seller would profit
by $5 per share and the buyer would lose his $5 per share.
Options are traded on specific stocks. They detail
the name of the stock, the strike price (the price the stock can be
bought or sold at), the expiration date and the premium (the price of
the option itself). After the expiration the option cannot be exercised
and is worthless. Options have a value and are actively traded. An option
to buy Microsoft, for example, is listed like this:
MSFT Jan06 22.50 Call at $2.00
This tells us that an option to buy 1 share of Microsoft
at $22.50 before the third Friday in January 2006 can be bought for
$2.00. Options usually expire on the third Friday of the specified month,
and they are usually traded in lots of 100. To buy this particular option
you would have to pay $200 (plus brokerage fees).
An option to sell a stock is called a 'put option'.
This gives the holder the right (but not the obligation) to sell a particular
stock within a certain time period at a certain price. In this situation
the buyer is expecting the price of the stock to fall but does not want
to sell outright in case the price rebounds. The seller feels that the
price is stable or is willing to acquire the stock at the low price.
For example: An investor buys a put option on Microsoft
with a 'strike price' (the price the stock can be sold) of $35. The
current price of Microsoft is $40 and the cost of the put is $5. If
the price falls below $30 (strike price + cost of put) the buyer could
exercise his right to sell at a higher price than market. The seller
would have to buy the stock at the higher-than-market price but any
losses are offset by the $5 he made by selling the put. If the price
remains above $30 the put would not be exercised and the seller would
profit by $5 per share and the buyer would lose his $5 per share.
As can be seen, stock options can be used to protect
against loss or as an investment opportunity in their own right. They
are generally used as part of a trading strategy which combines the
purchase of stock with the purchase of options.
For example, in a bull (rising) market you could
buy stocks and call options and sell put options. This allows you to
take full advantage of rising stock prices – the stocks you buy
will rise in value, the call options will allow you to buy stock at
less than market prices, and if the market dips and the buyer of your
put option exercises it, you can pick up additional stocks at low prices.
If the buyer does not exercise the option, you make money from the sale
of the option.
Conversely, in a bear market, you can sell stocks,
sell calls, and buy puts to limit losses and generate profits. Unstable
markets can use a mixture of puts and calls to maximize profit potential.
Options are traded on Futures and Options Exchanges.
There are 6 such exchanges in the United States including the American
Stock Exchange (AMEX) and the Chicago Board Options Exchange (CBOE).
In Europe the main options exchanges are Euronext.liffe and Eurex.
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