Stock Options - What you Need to Know

Call and What?

An option is a “legal financial contract”. The holder has the right, but is under no obligation, to accrue or sell a predetermined number of stock shares. This is to be done at a price that has been predetermined which is called a strike price. It is also to be accomplished on or before a specific date.

There are just two basic types of stock options, the European and the American. An American stock option is a contract that can be exercised between the purchase date and the expiration date.

Each stock option is designated by the following:

• Name of the stock
• Strike price
• Expiration date
• The premium that was paid for the option plus the broker’s commission

Two of the most popular types of stock options are Calls and Puts. If you own a call you have the right but are not obliged to buy a stock at the strike price at any time before the stock option expires. If an option expires, it is useless and worthless.

The other most common stock option is the PUT. This is almost the exact opposite of a Call. If you own a put you have the right, but are not obliged, to sell a stock at the strike price any time before the expiration date of the option.

How in the world do people trade these stock options? Stock options traders will rarely exercise their option and purchase (or sell) the underlying security. Instead, they will buy back or sell the option. This saves on commissions.

Options officially expire on Saturday following the third Friday of the month in which the option expires. Shares of stock have a 3-day settlement interval but option settle the very next day. The option has to be traded by Friday in order to settle on Saturday.

Another thing you may hear about with regards to stock options is volume and open interest. Volume is the number of contracts that are traded on any given day. The open interest figure is the number of contracts that are outstanding at any given time.

For those who are curious, a Put-Call theorem has been formulated which defines the following relationship for the price of puts and calls:

P=C-S+E+D
• P= the price of the put
• C= the price of the call
• S= the stock price
• E= the present value of the exercise price
• D= the present value of the dividends

An ordinary investor will see a violation of the put-call parity from time to time. This is not a time to instantly buy, but it is a reason for you to check your quotations for timeliness because as you will probably see at least one of them has expired.

If you want to get into the stock option trading business, then you should probably start by writing covered call option for stocks that are currently trading below the strike price of the stock option.

There are many places on the Internet if you do a search for stock options where you can set up an account for just a small amount of money. My advice to you is to do your research well and only put up as much money as you are willing to part with.