When people have extra money they want to invest, they can do so by buying stock options. Hopefully, this article can give you the basics of how stock options work.
First, what are stock options?
It is an agreement between two parties. This contract gives the buyer the right to buy or sell a share at a particular price. The buyer can exercise this right until an agreed expiration date.
What gives the buyer the right to buy a share is called a “call.” The option that gives the buyer the right to sell a share is called a “put.” And these options can be used at any time until the expiration date.
Stock options typically come in pools of 100 stocks. The group of 100 is known as a “lot”. And the price at which the lots are bought or sold is known as the “strike price.”
Here is an example of a stock option:
Let’s say you want to buy an option on shares of the Ramey company. Let’s say the stock price is $ 210. So, you buy a stock option (equal to 100 shares) at an exercise price of $ 200. And let’s say this option expires in six months.
If the Ramey Company stock price falls to $ 190 before the six months are up, you can exercise your right to sell the option, which is equal to 100 Ramey Company shares at the original exercise price of $ 200. You can do this at any time before the expiration date ends.
That is, when the shares of the Ramey company are at $ 190 a share, you can buy 100 shares at $ 190 and sell them at $ 200 a share. Therefore, you make a profit of $ 10 per share, even though the share price went down.
Now, here is an example of a stock option.
Let’s use the example from Ramey’s company above, except that you are buying a call option for $ 200. And let’s say this time, the stock price goes up to $ 300. Now what you can do is exercise your option to buy 100 Ramey company shares at $ 200 and then sell them for $ 300.
Things to keep in mind:
If you buy a call option and the share price never rises above the strike price, the option will be worthless once the expiration date is reached. And, of course, this is true for a put option: if the share price never falls below the strike price, the option will have no value on expiration date.
And, of course, there is the cost of the option itself. This is called the “premium” for the option.
There are many places to find out more about stock options. It is suggested that you visit various websites dealing with stock and options trading before getting too involved. And make sure you don’t spend money that you can’t afford to lose. Good luck!