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Overview
A stock option is a financial instrument that gives you the right to purchase or sell a specific stock at the strike price of the option by exercising the option. The specific stock is called the underlying stock. A stock option holder is not required to purchase or sell stock. The option holder can exercise the option prior to the stated expiration date of the option contract. Investors can buy or sell options in a brokerage account that allows option trading. Options are traded on option exchanges with the help of a broker. Option exchanges and brokerages notify option investors of the exact expiration date of stock options.
Types
Call options and put options are the two types of stock options. A call option holder has the right to buy the underlying stock at the strike price. For example, a Walmart call option with a strike price of $40 that expires next month allows the option holder to purchase 100 shares of Walmart stock at $40 per share anytime prior to the end of trading on the day that the option expires.
A put option holder has the right to sell the underlying stock at the strike price.
Function
Option investors can buy options and sell the options for a profit without ever exercising the options. Call options typically go up in price as the underlying stock goes up in price. Put options typically go up in price as the underlying stock goes down in price. Option investors can also short sell options and buy the options back later to cover their short positions and close out the option transaction. A seller of call options is obligated to buy the underlying stock in the event that the call option buyer exercises his call options. Some stock investors sell call options that are covered by the underlying stock that they own.
Time Frame
The trading price of options includes a time premium that erodes as the option expiration date approaches. Time premiums can increase or decrease based on the volatility of the underlying stock's price. If a call option buyer holds a call option until the expiration date, then he receives a settlement that is equal to the amount that the option strike price is lower than the closing price of the underlying stock. If a call option expires when the underlying stock price is less than the option strike price, then the option is worthless and the option holder receives no settlement for the option.
Considerations
Stock option traders need to pay attention to the trading price of the underlying stock when deciding whether or not to trade a particular stock option. Purchasers of stock options should not purchase call options if they believe that the underlying stock will have a lower price on the option expiration date. Put options should not be purchased if the underlying stock is expected to have a higher price on the option expiration date. Investors who have brokerage accounts that permit them to trade stocks do not automatically have option trading privileges. Many brokers will require investors to submit a satisfactory option trading application before they will be allowed to trade options.
Warning
Options can be purchased on margin at many brokers. Margin allows an account to grow much faster than normal if proper trading decisions are made. If incorrect trading decisions are made, a margin account will lose money much more quickly than normal. Stock option investors need to be comfortable with large swings in the price on their investment, and they should only invest funds that they are willing to lose in the event of a bad trading decision. Investors should not trade options with funds that they need to pay their bills.
