Buying Stock Options

There are four main types of stock options available for buying and selling in the stock market. These four types can be placed into two main categories: "\call" options and "put" options. The first type is the long call option. If an individual thinks that the price of a stock will rise, he may buy a call option that gives him the right (but not an obligation) to buy the stock at the price it was originally. If the price does rise, the trader can buy it at the lower price and therefore make a profit. Similarly, a long put option allows a trader to sell a stock at a preset price if the stock rises in value. In contrast, a short option call can be purchased if an individual thinks the stock price will fall. If the price does fall, the individual can make a profit off of the drop in value by selling the stock at the price it was when he purchased the option. Likewise, a short put gives an individual the right to buy stock at its earlier, lower price should the price increase in the future.

Stock options have existed in the stock market and assets world for several centuries. The origins of stock options can be traced to the real estate market and the buying and selling of property. The idea of trading options rather than hard assets was then incorporated into other markets, such as agriculture and entertainment. With the creation of government bonds, finance options became vogue. British Commonwealth residents were trading finance options as early as the 1690s. In the United States, stock options quickly became mainstream. While the practice has been in place in the U.S. for over a century, specifics have changed. For example, stock options were once relegated solely to the primary stock markets and had a longer expiration date. Now, traders have more flexibility when it comes to buying and selling stock options.

Stock options are a significant business strategy for finance companies and individual traders who wish to diversify their investment portfolio. The University of Pennsylvania's Finance and Investment department estimates that more than 10 million Americans hold stock options from their employers. Unlike actual stocks, with which profits are largely tied to rising prices, stock options allow traders and companies to also profit off of falling stock prices. In this way, stock options are a significant component in trading, though the extent of this significance largely depends on the ratio of options-to-stocks in a portfolio, and a trader's success with predicting the rise and fall of the stock market.

Due to the potentially high risks involved in buying stock options, it is best to consult with a financial advisor before trading stock options or vesting large amounts of money in the option market. Unlike the primary stock market, in which stocks are traded in a linear fashion across a timeline which thus enables relatively confident predictions and market forecasts, stock options fluctuate in a non-linear fashion. Whereas the success of a stock can easily be determined, the success of a stock option relies on far more variables. In this way, the risks of stock option trading is much higher than traditional stocks. This level of complication can create confusion for novice traders and increase the likelihood of large amounts of monetary loss. For example, most stock options do not cap the amount in which a stock can depreciate. If a stock begins to fall in price and the stock option owner does not exercise his right to sell the stock, the trader can theoretically lose the complete value of the stock.

Determining the value of a stock option requires understanding the basics of the stock market. One of the main considerations that option traders take into account is the valuation of the stock option according to the Black-Scholes valuation model. The basics of this valuation model requires a trader to look at several variables. First, the trader must undertake basic market research and know the current asking price of the stock, and the price of the option. The trader should also determine the potential cost of holding the option at the current market price of the stock and its potential to rise or fall in relation to this price. Finally, the trader should factor in the expiration date of the stock option in order to predict whether holding the stock option will lead to future profits or losses in relation to when the stock option expires and becomes worthless.