Option Trading
Stock options provide advanced investors with additional opportunities for potentially rewarding returns. But stock options also involve risks, so a good understanding of options will help you minimize risk and maximize your profits as an option trader.
Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options to hedge against a price decline, to lock in a future purchase price, or to speculate on the future price of a stock.
A stock option is essentially a contract that gives one party the right to purchase or sell a stated number of shares of a stock at a specified price. The price at which the shares may be purchased or sold is known as the strike or exercise price. The right to exercise lasts for a stated period of time, which may be months or years, until the expiration date. If not exercised on or before the expiration date, the option expires.
Options come in two forms: calls and puts. A call option gives the option purchaser the right (but not the obligation) to buy 100 shares of the underlying stock at the strike price from the date of purchase until the expiration date. A put option gives the option purchaser the right (but not the obligation) to sell 100 shares of the underlying stock at the strike price from the date of purchase until the expiration date.
A call option becomes more valuable as the price of the underlying stock increases, all other things being equal. So option traders puchase call options when they are bullish on the market.
A put option becomes more valuable as the price of the underlying stock decreases, all other things being equal. So option traders puchase put options when they are bearish on the market.
With both calls and puts, the purchaser of the option has the right to exercise, while the option seller is obligated to respond if the option is exercised. The option purchaser pays an upfront fee known as the premium to the option seller in return for the right of exercise. The option buyer has a known investment risk -- if the option expires unexercised, the purchaser of the option recognizes the premium paid as a loss. Conversely, the option seller undertakes potentially unlimited market risk in return for the premium received.
Option contracts are traded on regulated markets, and their values may fluctuate throughout the trading day. The market price of an option at any given time is governed by supply and demand, however the theoretical fair value of the option is based on several factors (most of which are known), including the current price of the underlying stock, the strike price, the price volatility of the underlying stock, the time to maturity, dividend yield of the underlying stock, and risk-free interest rates.
The option premium can be broken into two components: intrinsic value and extrinsic or time value.
The intrinsic value of the option is the difference between the exercise price and the price of the underlying security. An option is "in the money" when the intrinsic value is positive. The extrinsic or time value of the option is the option premium minus the intrinsic value. The more time remaining until the expiration date of the option, the greater the potential for a significant change to occur in the price of the underlying security and the greater the time value of the option. Time value diminishes as the expiration date of the option approaches.
When you are analyzing potential option positions, it
helps to have a computer program like Option-Aid that
swiftly calculates volatility impacts, probabilities,
statistics, and other parameters of interest. These
programs can pay for themselves with the first trade that
they help you with.
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