Understanding Stock Options

What are stock options and how do you use them? Think of them as a contract. You agree to buy or sell a stock at a certain price on a specified date in the future.

If you are the buyer, you have the right to buy the stock at the price which is specified, but you do not have to exercise this option. On the seller’s side, you must sell the underlying stock if the buyer of the option wishes to exercise it.

Calls

A call option is a contract to purchase. If you are the buyer, you want the price of the underlying stock to rise, which would allow you to buy it for less than the market value at the time. As the seller, you want the price of that stock to stay the same, drop, or you are even willing to see a small rise, giving a partial profit from selling the call option.

The strike price is the price the stock can be bought or sold at. The name of the stock, this strike price the expiration date and the premium or the price of the option itself is provided. Once it has expired, the option can not be exercised and it is then worth nothing. Until the expiration, the option itself has value and can be traded on the market.

An Example

MSFT Dec06 23.45 Call at $4.00.

This is an option to buy Microsoft at the given price of 23.45 before the third Friday of December of 2006 can be purchased at the price of $4.00. They are normally traded in lots of 100. So,in our example, you would have to pay $400 plus your broker’s fees to purchase this option.

A put option is the opposite of a call -- it is an option to sell. The holder of the option has the right to sell the stock within a certain time frame at the given price. The buyer is expecting the price of the stock to fall, but does not want to sell outright just in case he can make some money on it. The put seller believes the price to be a stable one.

Stock Options In An Overall Strategy

Stock options can be used to protect against loss. They can be an investment opportunity in itself as well. Most of the time, they are used as part of a trading strategy which would combine the purchase of options and the purchase of stock.

In a bull market, a buyer can purchase stocks and call options and sell put options. Why? To allow full advantage of the rising stock prices to be realized. The stocks will rise in value and the call options allow you to buy stock for less than what the market is at. If the market heads down, the buyer of the put option will use it and then you can purchase additional stocks for these lower prices. If he doesn't, you make money from the sale of the option.

In a bear market, sell stocks, sell calls, and buy puts which will limit your losses and also help to generate profits. You can also do a mixture of these options when the market is unstable.

The goal is always to make a profit while limiting risk.

Many, but not all, stocks have options that are traded on them. Options are traded on Futures and Options Exchanges, which include the American Stock Exchange, the Chicago Board options Exchange and the Euronext.liffe and Eurex.