What is an Options Contract?
An option, or more formally an equity option, is a contract that gives the holder the right to buy or sell shares of an underlying stock at a specific price, known as the strike price, from the date of purchase until a specific expiration date in the future. Options contracts generally represent the right to buy or sell 100 shares of the underlying stock.
There are two kinds of options: Calls and Puts
A call confers to the buyer the right to buy shares at the strike price, and a put confers the right to sell shares at the strike price. However, the buyer of an option is under no obligation to exercise this right, whereas the seller is obligated to buy shares from a put buyer or sell shares to a call buyer. If the right is not exercised by the expiration date, the option ceases to exist, and therefore no longer holds value.
Right to buy
Obligation to sell
Right to sell
Obligation to buy
What is the Strike Price, and Premium?
The strike price is a fixed number that never changes. Strike prices have even increments that depend on the price of the underlying stock. A more expensive underlying stock will have larger strike price increments. The value of the option is known as the option’s premium, and changes frequently, usually in correlation to changes in the underlying stock price and the passing of time.
What is the Expiration?
Generally, there are always calls and puts available for purchase at a range of strike prices and with a range of expiration dates. An option with an expiration date further in the future will have a higher price. There are usually at least four expiration dates available for options of a particular stock, each on the third Friday of a different month. If that Friday is a trading holiday, the expiration date moves to the Thursday before that Friday. More recently, services have started offering options with much shorter term expiration dates, often times, one every week.
How does Options Trading differ from traditional stock trading?
There are several beneficial aspects to options that are not found in traditional stocks. For instance, the potential loss for the buyer of an option is limited to the price that the contract is bought for, and the potential gain is unlimited. However, the writer or seller of the contract has unlimited potential for loss. Additionally, options can often be cheaper than shares of an underlying stock and make it possible to invest meaningfully with limited capital. There are also several strategies that allow a trader to hedge against market losses from an underlying stock using options of that stock.
If the option’s underlying stock splits or merges, changes may be made to the option’s size, strike price, or deliverables. Additionally, option holders do not have the same rights guaranteed to holders of the underlying stock, such as special dividends or voting rights. Options prices are controlled by the individual buyers and sellers, in an auction style market.
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