Stock Options: An Introduction
For people that are unfamiliar with stock options, the idea would seem confusing even dumbfounding. For those that have already heard of stock options, the concept of investing or trying out options can be intimidating, even to the point of driving you away. The first thing that you should know about stock options is that it is risky. But then again, investing in the stock market is risky for anyone. What is rather sad is that people tend to walk away from trying out stock options because they don’t understand or don’t want to understand what stock options are and how one can benefit from it. That’s right; stock options do not just involve risks. It also gives you a possibility of earning profits. So my suggestion is, before saying no to stock options, try and understand how it works. At least then, you can make an informed decision whether you want to walk away or not.
Stock Option Defined
A stock option is the contract that gives you, the holder, the power to demand that the stocks be sold (or bought) from you at an agreed price, on or before a specified time arrives. Just like any contract it is binding on you and the seller of that option and that you as the buyer of the option must pay a compensation to have that option. However, since it is an option, you have the power to exercise or not exercise that option. Each option contract involves buying or selling of 100 shares of stocks.
An option is often referred to as a derivative because its value comes from another thing called underlying asset. To make stock options easier to understand lets use an example. Assuming you want to buy a house and you find out it has a price of $200,000. You don’t have that kind of money with you yet so you enter an option contract with the seller. The option contract says that for the price of $3,000, you have the choice of buying that house for $200,000 within the next 3 months. This means that the seller of the house cannot sell that house to anyone else within the next 3 months. It also means you have to pay the $3,000 as compensation to have the choice of buying or not buying the house within 3 months. Assuming that after 2 months the value of the house skyrocketed to $300,000, the seller of the house cannot force you to buy that house for $300,000. Because of the option you can buy the house for only $200,000. If you don’t come up with the money within 3 months the option contract expires and you lose your right to buy the house at $200,000 as well as the compensation you paid which is $3,000.
This illustration shows how call options work. The house is the shares of stock and the underlying asset from which your stock option derives its value. If you buy a stock option you can secure for yourself the exclusive right to buy 100 shares of stock at a particular share price within a period. You may or may not exercise the option to buy, but either way you have to pay the premium or compensation, in this case the $3,000, to have the option to buy or not to buy. This is a simple but incomplete depiction of stock options. I hope that by reading this you get a general idea of how stock options work.