Trading stock options shares some similarities with ordinary stock trading, but it also has some very substantial differences. It is almost impossible to know if options trading is something you should be doing until you understand some of the basic concepts and terminology. Options trading has a language of its own, so it stands to reason if you are interested in getting involved in trading stock options you really have to learn the jargon before you can get going.
The basic concept involved in trading stock options is that traders purchase the right to either buy or sell some specific stock for a specific price before a specific time in the future. In other words the trader locks in a price which he may or may not act on before the specified time limit.
Buying the right to a guaranteed future price costs a bit of money. In some regards it is like putting a "security deposit" down on a rental property. When you give the owner a security deposit the two of you are agreeing that you have the right to rent the property for the agreed-upon price. If you exercise that right the owner of the property agrees to have the property available for you, and if you do not exercise the right, you forfeit your security deposit.
Let's take an example of a very simple stock option agreement and then define the basic terminology involved in the agreement. Say, for example, you want to buy the right to purchase 100 shares of XYZ123 stock sometime before the end of May, for $65 each. This is called a "call option". You have reason to believe that the stock which is currently valued at $60 may go significantly higher within the next two or three months. So by paying a relatively small "premium" you lock in the price you are prepared to pay for the stock by purchasing a contract that guarantees for a limited time period you will be able to buy the stock for that price.
Say the price goes to $75 sometime in early May. You can then exercise your option to buy at the agreed upon price of $65. If the price does not go up enough you can just let your contract run out without exercising the option to buy. In that case you have just paid the "premium". This is not a completely insignificant amount, but not an amount that hurts as much as actually buying stock that does not perform as you hoped it would.
In order to even begin trading stock options you have to know some of the jargon used by options traders. First, it is important to understand that stock options are normally purchased for blocks of 100 shares. Second, the two most common types of options are the "call" option and the "put" option. In the case of the first (the "call" option) you are purchasing the right to buy stock at a specific price, and in the case of the second (the "put" option) you are purchasing the right to sell stock at a specific price.
A "call" option sets a time frame within which the buyer has the right to buy the underlying stock for a set price. A typical scenario in which an investor would buy a "call" option is the one described above: where you pay a premium to lock in a buying price on a stock which you think has a good chance of going above that buying price.
A "put" option sets a time frame within which the purchaser of the option can sell the underlying stock for a set price. A typical scenario where an investor would buy a "put" option is where that person is prepared to pay a premium to lock in a selling price. Often this is used as a hedging strategy to protect against having to hold a stock if it falls in value below a certain level.
The selling price set by the option contract in either case (call or put option) is called the "strike price". So, for example, if your contract says you have the right to buy a stock at $65 any time before the end of May, the strike price is $65. In that case the "expiration date" of the contract is normally the third Friday of the month - in this case, the third Friday in May.
A call option is said to be "in the money" when the strike price set in the contract is below the current market price of the underlying stock. So for example, if the strike price of a call option is $65 and the current market price is $75, then that option is said to be "in the money" because exercising it would result in a profit.
In the case of a put option it is said to be "in the money" when the strike price is above the current market price. In other words, the option lets you sell the stock for more than it is currently trading for.
A call option is said to be "out of the money" when the strike price is higher than the current market price. For a put option it is said to be "out of the money" when the strike price is lower than the market. When an option contract - either a call or a put - is "out of the money" the investor holding the option will typically not exercise it, because to do so would cost money.
These are just some of the basic concepts and terminology used when trading options online. As an options trader becomes more experienced and sophisticated these basic concepts lead to the development of much more complex investing strategies than the ones discussed here.
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