A stock option is a financial contract that gives an investor the access, but not necessarily a responsibility to buy or sell shares of a chosen stock at a stated price for a quantified period. Stock options are traded by investors on exchanges. Sometimes, the price of the stock option might be lower or higher than the originally listed price of the stock. An employer can also offer a stock option to the employees; offering an employee the stock options gives them the right to buy a chosen shares at a fixed price for a quantified period.
In stock option, the seller of the option is referred to as an option writer; then, the seller is paid a premium from the contract acquired by the stock option buyer. There are two significant types of stock option:
Call Option: this is an option that gives the buyer the right but not an obligation to buy stock. When the worth of the primary stock increases, the value of the call option will also increase.
Put Option: a put option gives a buyer the right to sell a stock short. Contrary to the call option, when the worth of the primary stock increases, the value of the put option will drop.
There are specific terminologies that need to be explained to get a better understanding of stock option:
Expiration Date: the expiration date allows the investors to predict the particular date when a chosen stock will rise or fall. The expiration date assists the investors to price the worth of the put and call of the option.
Styles: there are basically two types of stock options American and European. The European option is less common and is commonly exercised over mainly the expiration date. The American option, on the other hand, can be utilized at any time between the purchase and expiration date.
Strike Price: the strike price is the value that the investor expects a chosen stock to rise or fall by. The strike price will determine whether a stock option should be exercised.
Contract: the contract denotes the number of available options available for an investor to buy. In stock options, one contract equals 100 shares of the primary stock.
Premium: The premium is determined by multiplying the price of the call by the number of contracts acquired.
Trading Option: based on the strategy an investor is using, options can be bought or sold. An investor has the choice of either selling or buying an option based on the approach he chooses.
To finally conclude, I will give a real-world application to enable readers to understand the concept better. An investor can predict based on analysis a stock X will increase in value. The investor will place an expiration date for the stock. For the investor to earn a profit, the chosen stock would need to rise above the predicted price (strike price). If the price, however, falls, the investor will lose the premium (profit), and the options will be worthless.
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