How stock options are traded

Many traders think of a position in stock options as a stock substitute that has a higher leverage and less required capital. After all, options can be used to bet on the direction of a stock's price, just like the stock itself.

However, options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn. Options Two types of options are calls and puts. When you buy a call option , you have the right but not the obligation to purchase a stock at the strike price any time before the option expires.

When you buy a put option , you have the right but not the obligation to sell a stock at the strike price any time before the expiration date. One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: So, for every call or put option purchased, there is always someone else selling it.

When individuals sell options, they effectively create a security that didn't exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date.

When you write a put, you may be obligated to buy shares at the strike price any time before expiration. Trading stocks can be compared to gambling in a casino , where you are betting against the house, so if all the customers have an incredible string of luck, they could all win.

Trading options is more like betting on horses at the racetrack.

Options Basics: What Are Options?

There they use parimutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities.

So, trading options, like the horse track, is a zero-sum game. The option buyer's gain is the option seller's loss and vice versa: Option Pricing The price of an option is called its premium.

The buyer of an option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.

Getting Acquainted With Options Trading

In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver if a call option or taking delivery if a put option of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be open-ended, meaning the seller can lose much more than the original premium received. Option Types You should be aware that there are two basic styles of options: An American, or American-style, option can be exercised at any time between the date of purchase and the expiration date.

Most exchange-traded options are American style and all stock options are American style. A European, or European-style, option can only be exercised on the expiration date.

Many index options are European style. When the strike price of a call option is above the current price of the stock, the call is out of the money ; when the strike price is below the stock's price it is in the money.

Put options are the exact opposite, being out of the money when the strike price is below the stock price and in the money when the strike price is above the stock price. Note that options are not available at just any price. Also, only strike prices within a reasonable range around the current stock price are generally traded.

Far in- or out-of-the-money options might not be available. All stock options expire on a certain date, called the expiration date. For normal listed options , this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called LEAPS , are also available on many stocks, and these can have expiration dates up to three years from the listing date. Options officially expire on the Saturday following the third Friday of the expiration month.

But, in practice, that means the option expires on the third Friday, since your broker is unlikely to be available on Saturday and all the exchanges are closed. The broker-to-broker settlements are actually done on Saturday.

Unlike shares of stock, which have a three-day settlement period , options settle the next day. In order to settle on the expiration date Saturday , you have to exercise or trade the option by the end of the day on Friday.

The Bottom Line Most option traders use options as part of a larger strategy based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them.

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Getting Acquainted With Options Trading By Jim Graham Share. Options Basics Options Two types of options are calls and puts. Trading options is not easy and should only be done under the guidance of a professional. The ability to exercise only on the expiration date is what sets these options apart. Learning to understand the language of options chains will help you become a more informed trader.

A brief overview of how to profit from using put options in your portfolio. Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums. The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably. Learn how aspects of an underlying security such as stock price and potential for fluctuations in that price, affect the Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered Learn how the strike prices for call and put options work, and understand how different types of options can be exercised Learn about investing in put options and the associated risks.

Explore how options can provide risk, which is precisely defined The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. A period of time in which all factors of production and costs are variable.

In the long run, firms are able to adjust all A legal agreement created by the courts between two parties who did not have a previous obligation to each other.

A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation.

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