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LEARN ABOUT OPTION

OPTION BASICS

Raw Theory:
Option is a contract that gives you the right to purchase something at an agreed price.

Example: You would like to purchase a property that you like at 200k, but would like to have the opportunity to go through you financials and family before you commit. You may purchase an option-to-purchase from the seller of the property that ‘gives you the rights to buy the property at 200k’. This option may cost you 2,000 and has an expiry in 2 weeks. The seller would be under ‘Obligations to sell’ the property to you at 200k

Within 2 weeks you may:
Exercise the option and purchase this property at 200k.

Or

Decide due to financial or family considerations, not buy this property at all. Hence, losing 2,000 that you have used to purchase the option.

However, assume that the property’s price due to sudden surge in property demand at the area has surged to worth 210k. You may like to sell your option-to-purchase to another interested party more than the 2,000 you paid. Since it is a contract to buy it for 200k instead of the market price of 210k, probably it is worth more like 8,000(in theory) since 200k + 8000 = 210k.

Of course, you can still go ahead and purchase the property since the seller is under obligations to sell to you at 200k. Hence you make a saving of 8,000.

In Stock Market

In the stock market, the stock price that you would like to do the transaction of the stock is the strike price. This is a specific price that you may like to ‘buy’(or sell) the stock, and since the stock price may fluctuate throughout the day the price of the option will fluctuate. How it fluctuates will be discussed in the next chapter.

Call Option

Definition: An agreement that gives the buyer the right(but not the obligation) to purchase the stock at the strike price stipulated within a time period. The seller of the option is obliged to sell the stock to the buyer at the stipulated strike price.

The call option is very much like the property example given. You have purchased the opportunity to own the stock at the strike price within a time period(called expiry). If the price of the stock goes up, you will stand to gain with the corresponding increase in the call option price. However, if the stock price goes down you will loose money. But of course, the maximum loss you would pay for is the money that you spent(together with brokerage charges) to buy the call option.

Example: Look at the option chain above. If you buy at strike price of 95.00 and that the current NKE price is at 97.70, you would have paid 3.90 for the call option NKEBS. If NKE stock price goes up to 100.78, the price could rise to 5.00 or more and hence the opportunity for profit. If you do decide to wait till expiry in Feb 2007 and the price rises further to 105.42, you could own the NKE stock by paying 95.00 instead of 105.42.

However, if the price drops to 90.21 by then, the call option is worthless as there would not be any buyer interested to purchase a contract to buy something that they can pay less for at 90.21 instead of the 95.00.

In a Nutshell: The price of a call option rises and falls together with the stock price.

Put Option

Definition: An agreement that gives the buyer the right(but not the obligation) to sell the stock at the strike price stipulated within a time period. The seller of the option is obliged to buy the stock from the buyer at the stipulated strike price.

The put option is an opposite of a call in that it gives you the right to sell the stock at the strike price instead of buying. Which means that if you bought a put option and the price of the stock went up, assuming you do not have the stock on hand, you would have to buy the stock at a higher price and then sell it to the option seller at the stipulated strike price.

Example: Look at the above option chain again. Assuming you purchase a put option NKENT at 3.00, strike price at 100.00. If the price of NKE increases from 97.70 to 101.20, the price of the option will drop and upon expiry, you would have to buy NKE stock at 101.20 and sell them for 100.00, making a loss of 1.20(stock price loss) + 3.00(option price) = 4.20. However, if the stock price falls from 97.70 to 95.09, the price of the option would increase since now you can sell the stock for more than what it is worth. Upon expiry, you could buy the stock at 95.09 and sell it at 100.00.

In a Nutshell: The price of a put option rises and falls in opposite to the stock price.

Buyers vs Sellers

Buyers of options always have the right and sellers always have the obligations to fulfill their contractual rights.

This means that when a buyer choose to exercise his option, say a put option. The seller must fulfill his obligations by buying the stock from the put option holder at the stipulated price. Which means that a buyer’s risk is limited to the price paid for the option, and the risk of the seller is unlimited, in the sense that the price may go up or down indefinitely.

In a Nutshell: Option buyers have limited risks and option sellers have unlimited risk.

So why would anyone want to be a seller?

Time decay (refer to next chapter) works well for option seller and works against the option buyer. As long as the contract expires without any benefit for the buyer, the seller gets to keep the money for the option sold.

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Disclaimer: Option Trading has potential risks and could loose alot of money. Do understand the risks involved before pursuing any trades. Please be aware that our website does NOT recommend any specific stocks or option purchases. Examples used are for educational purposes only. Option Trading Resource is not responsible for stock or options recommendations linked from our sites as we have no control over the sites content. We strive to provide the best information and we do update our site daily.