Stock Option Concepts Explained: The Basics you need to Know

In the world of stock options trading, there are things you need to remember in order to be successful in this type of investment.

It is important to keep in your mind the basic ideas and concepts on stock options. It will help you determine whether you will lose or you will profit.

To start with, stock option is a particular type of option that uses the stock itself as a principal instrument to determine the option’s pay-off or its value. In other words, it is a contract to purchase or sell a certain number of shares of stock at a pre-determined price.

There are two types of contracts involve stock options that you need to know. The first is the call option, where a buyer has the right to purchase the principal shares of a certain stock set at a predetermined price and date. Keep in mind that the buyer has the right but not the obligation to do it.

The second type is the put option. The buyer has the same fundamentals but sells principal shares. He has the right of doing it but cannot be obliged.

The same rules of the predetermined price and date of a certain share is applied. The buyer is required to deliver the shares only if they exercise the option.

Here is a good example a stock option trade. For instance, you own an option to purchase a share in a certain corporation for $200 in a one-month period.

If the actual stock price at that time is $205, then you have the right to exercise or to use your option and purchase stocks from anyone who will sell you the option for $200. You can either keep the stock or sell it in the open market for $205, thus making a profit of $5.

However, if the stock price was only $190, you will not exercise your option if you really wanted to own a share in that corporation. You could buy that share in the market for $190 rather than exercising option to purchase it for $200.

If you own a stock option, you can generate a profit but not to make a loss, except for the cost of the option itself. It is advantageous for you since you will have an idea on obtaining a certain share without losing.

A stock option contract’s value is dependent on five principal factors.

1. The price of the stock itself,

2. The strike price or the price of the option that is agreed by both seller and the buyer,

3. The increasing cost required to hold a position in the stock which includes interest plus dividends,

4. The expiration date, and

5. The estimate of the future instability of the stock price.

Trading standardized options contracts is the most common way of trading stock options. These contracts are listed by different futures and options exchanges based on principal stocks.

Currently, six exchanges exist in the United States that lists such contracts. These are the following:

1. Philadelphia Stock Exchange (PHLX)
2. American Stock Exchange (AMEX) in New York City
3. Pacific Exchange (PCX) in San Francisco, California
4. Chicago Board Options Exchange (CBOE)
5. International Securities Exchange (ISE)
6. Boston Options Exchange (BOE)

There are also independent trades or so-called over-the-counter options contracts, which are not done on exchanges. It is initiated between two independent parties; usually one of it is a large financial institution with a balance sheet enough to guarantee such contract.

These are the basic of stock options. It is important to keep in mind these concepts before you venture into the world of stock options.

Learning the basics is synonymous to getting the grip of your career and be successful in it.