Buying and selling stock is not just confined to the market price of the share. People can take advantage of trading stock options. Stock options are nothing but a contract between the buyer and the seller where the buyer agrees to buy shares at a future date. Like stock, stock options also have value with some difference. However, you need to have stock options explained in detail to you. Understanding of stock options trading gives traders, a leverage thus reducing risk. As the name suggests, a stock option is just an option not an obligation, to buy or sell a stock at an agreed upon price. Understanding stock options as it is explained requires knowledge of a couple of jargons commonly used while trading. Let’s take a look at what these jargons are.
As mentioned earlier stock option is the right to buy or sell a stock at some point in future as per the contract. The right to buy a stock is termed as a call option and the right to sell a stock is termed as a put option. The agreed upon price at which the stock is sold or bought in the future is coined as a strike. The buyer has to pay the seller a premium for the risk that comes with the contract. Premium depends upon the strike price as well as the time for the expiration of the contract. The entire stock option expires after a certain period of time. Expiry of a stock option falls under a contract and varies with a different contract. In the US, every stock option expires on the third Friday of the expiry month. Make sure you read the contract and the points that are explained well before you go ahead with a stock option.
Let’s take a small example to understand stock options which is explained in a simple way. Mr. A wants to buy a stock XYZ in future. He wants to buy 100 shares which is currently priced at $8 for $10 by the end of the month according to the contract. This is called a call option (not an obligation) by the end of the month. If the stock price exceeds $10 say $11, Mr. A would profit $100 by selling the share for $11. But at the same time, he has to pay $50 as the premium to the seller which is agreed and mentioned in the contract. So the net profit is $50. What if the price falls to $9? In this case, Mr. A would naturally incur a loss of $100 by selling them so he can just drop out of the option and pay just the premium of $50 to the seller. In this case, the seller makes the profit. The buyer pays a premium to purchase the put option from the seller.
The profit earned can be represented in a very simple formula:
Profit= [(Current Market Price-Strike Price) *(No of shares)]-Premium.
So, if Mr. A has an option contract for 100 shares of XYZ at $20 and the current price is $25, with a premium of $1 dollar a share that is $100 in total as premium, Mr. A will earn a profit of [(25-20) * 100]-100=$400.
There are two situations. One from the seller’s point of view and the other from the buyer’s point of view. The stock option will be easy for you to understand as it is explained.
- Purchasing Call option is buying shares of a stock, where the buyer has the right to buy shares (termed lot size) for a price before the contract’s expiry.
- Purchasing Put option is selling shares of a stock, where the seller has the right to sell shares of stock before the expiry of the contract.
Advantages of stock options:
- Risk Reduction: Options have less risk when compared to stocks. If Mr. A bought 100 shares of XYZ at $10 and if the price drops to $5 he naturally incurs a loss of $500 whereas in the case of a stock option he will let the obligation runoff that Mr. A can let the contract expire and just pay the seller the premium.
- Leverage: If Mr. A bought 100 shares for $10, his stake in the investment is $1000 and if the stock price rises from $10 to $11, He will earn a profit of 10% of the original value. If the value increases to $12, he will earn a profit of 20% of the original value. Now if Mr. A has a stock option of $9 for 100 shares which has a current market price of $10 and if the price rises to $11 during the period, Mr. A would make a profit of 20% of the original value. This will help the consumer to have leverage. The consumer should understand the stock option as explained.
- Trading on Prediction: Stock option is more of a pro-active method of trading than a reactive like in stocks. Buying stocks without prior knowledge of the annual share report could potentially ruin a buyer whereas in the case of stock options the trader only loses the premium as explained and mentioned in the contract.
Ideally it’s best to practice both stock and stock options. Buying stocks expecting a surge in the price and buying small amount of stock options so that even if the stock game takes a hit the stock options can support.