Options are perhaps one of the least understood aspects of the stock market; properly used, however, they can help to control investment risks and produce large profits.
Simply put, options are contracts which confer the right to buy or sell shares of a security at a specific price within a certain timeframe.
Purchasing an option does not incur any requirement by the buyer to fulfill the terms of the contract; all obligations are on the seller's side of the bargain.
The buyer of a call option pays an upfront fee, known as a premium, for the right to buy a certain amount of a security at an agreed-upon price, known as the strike price, within a specific timeframe.
A put option grants the right to sell a certain amount of a security within an agreed-upon timeframe at the strike price.
Not all stocks are available for options trading; tradable options are available on approximately 2,200 stocks.
Stock options are sold in increments of 100 shares.
Options contracts are available for a variable number of months, depending on the specific contract; while they technically expire on the third Saturday of the specific month, for all intents and purposes they are considered to expire on the third Friday of the month since the stock markets are not open on Saturdays.
Option prices depend on several different factors, including the security's current selling price, the agreed-upon strike price, the length of the contract, and the volatility of the underlying security.
Volatility is essentially a measurement of the likelihood of shifts in the market price of a security and the magnitude of those shifts without consideration of the direction of such shifts.
Investors use a number of mathematical models to determine volatility and consequent pricing.
Historical volatility is usually determined by a method called standard deviation; this is a relatively straightforward measurement of how far above or below the average a security's price has ever gone.
Price spikes or steep drops are both indicators of high volatility; the direction of price changes is not considered when determining the volatility of a security.
Implied volatility is more speculative; it compares the hypothetical fair price of the security against its current market price to determine what a likely future price will be, and measures the difference between the two.
Options prices are based in part on these two predictors of volatility, as well as the current market price of the security, the strike price, and the length of time specified in the contract.
Generally speaking, put options are considered bearish.
This means they reflect a pessimistic view of the likely future price of the underlying security.
The buyer pays a premium for the right to sell their stocks at an agreed-upon price; this allows the put option buyer to protect against sharp price downturns on his underlying investment.
If prices fall far enough, it will become profitable to exercise the put option.
This will require the option seller to purchase those stocks at the agreed-upon price, generally higher than the current market price.
Essentially, a put option creates a floor for the price of the underlying securities, allowing the purchaser of the put option to guarantee that the value of those securities will not fall below a certain level regardless of the market price.
Of course, this guarantee only lasts for the duration of the contract, usually four months or less.
Call options, on the other hand, are considered bullish because they are predicated on the belief that the price of the securities will go up.
Call option buyers anticipate that the value of the securities will exceed the strike price, allowing the purchase of the underlying securities at a lower price than the current market price and subsequent resale at a profit.
Call options allow buyers the right to buy stocks at a specific price for a specific duration; since they are not required to purchase the stocks, they are basically buying the option to make a profit in the future if such a profit is possible.
Buying call options rather than purchasing the underlying securities allows buyers to moderate their risk; by purchasing a large block of call options, they can ensure that they reap the profits if the price goes up without assuming the risk that the price will instead go down.
Sellers assume the bulk of the risks in options trading.
Since the buyer of an option is not required to exercise that option, their risk is limited to the amount of the up-front premium.
Sellers are required to sell their securities at the agreed-upon price, regardless of the current market price or profitability, or to buy securities even if they are worth much less at the time the option is exercised.
While the premium is determined based on these risks, it cannot protect the seller from unexpected wide swings in price.
Essentially, options sellers are betting that the price of their securities will remain stable or move in the opposite direction than options buyers are predicting.
Options are among the most versatile of securities trading instruments.
Used properly, they can offer a measure of insurance against wide price swings and allow wider exposure in the market than simply buying or selling stocks can provide.
Market research and understanding the risks and rewards of options trading can allow investors to see significant gains over the long run.
Simply put, options are contracts which confer the right to buy or sell shares of a security at a specific price within a certain timeframe.
Purchasing an option does not incur any requirement by the buyer to fulfill the terms of the contract; all obligations are on the seller's side of the bargain.
The buyer of a call option pays an upfront fee, known as a premium, for the right to buy a certain amount of a security at an agreed-upon price, known as the strike price, within a specific timeframe.
A put option grants the right to sell a certain amount of a security within an agreed-upon timeframe at the strike price.
Not all stocks are available for options trading; tradable options are available on approximately 2,200 stocks.
Stock options are sold in increments of 100 shares.
Options contracts are available for a variable number of months, depending on the specific contract; while they technically expire on the third Saturday of the specific month, for all intents and purposes they are considered to expire on the third Friday of the month since the stock markets are not open on Saturdays.
Option prices depend on several different factors, including the security's current selling price, the agreed-upon strike price, the length of the contract, and the volatility of the underlying security.
Volatility is essentially a measurement of the likelihood of shifts in the market price of a security and the magnitude of those shifts without consideration of the direction of such shifts.
Investors use a number of mathematical models to determine volatility and consequent pricing.
Historical volatility is usually determined by a method called standard deviation; this is a relatively straightforward measurement of how far above or below the average a security's price has ever gone.
Price spikes or steep drops are both indicators of high volatility; the direction of price changes is not considered when determining the volatility of a security.
Implied volatility is more speculative; it compares the hypothetical fair price of the security against its current market price to determine what a likely future price will be, and measures the difference between the two.
Options prices are based in part on these two predictors of volatility, as well as the current market price of the security, the strike price, and the length of time specified in the contract.
Generally speaking, put options are considered bearish.
This means they reflect a pessimistic view of the likely future price of the underlying security.
The buyer pays a premium for the right to sell their stocks at an agreed-upon price; this allows the put option buyer to protect against sharp price downturns on his underlying investment.
If prices fall far enough, it will become profitable to exercise the put option.
This will require the option seller to purchase those stocks at the agreed-upon price, generally higher than the current market price.
Essentially, a put option creates a floor for the price of the underlying securities, allowing the purchaser of the put option to guarantee that the value of those securities will not fall below a certain level regardless of the market price.
Of course, this guarantee only lasts for the duration of the contract, usually four months or less.
Call options, on the other hand, are considered bullish because they are predicated on the belief that the price of the securities will go up.
Call option buyers anticipate that the value of the securities will exceed the strike price, allowing the purchase of the underlying securities at a lower price than the current market price and subsequent resale at a profit.
Call options allow buyers the right to buy stocks at a specific price for a specific duration; since they are not required to purchase the stocks, they are basically buying the option to make a profit in the future if such a profit is possible.
Buying call options rather than purchasing the underlying securities allows buyers to moderate their risk; by purchasing a large block of call options, they can ensure that they reap the profits if the price goes up without assuming the risk that the price will instead go down.
Sellers assume the bulk of the risks in options trading.
Since the buyer of an option is not required to exercise that option, their risk is limited to the amount of the up-front premium.
Sellers are required to sell their securities at the agreed-upon price, regardless of the current market price or profitability, or to buy securities even if they are worth much less at the time the option is exercised.
While the premium is determined based on these risks, it cannot protect the seller from unexpected wide swings in price.
Essentially, options sellers are betting that the price of their securities will remain stable or move in the opposite direction than options buyers are predicting.
Options are among the most versatile of securities trading instruments.
Used properly, they can offer a measure of insurance against wide price swings and allow wider exposure in the market than simply buying or selling stocks can provide.
Market research and understanding the risks and rewards of options trading can allow investors to see significant gains over the long run.
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