Stock traders use a lot of terms that may confuse those new to selling or buying in the market. One of the most common of these is options.
Traders use options to protect their investments, to raise funds quickly without risking their portfolio value, and to build wealth. But what exactly is a stock option?
A Simple Definition
The simple definition of options is just what the word implies. It gives the buyer or seller the right, or privilege, to trade the stock during a specified time for a specified amount. The person buying the option is not obligated to use it.
The seller must sell the stock at the specified price if the buyer exercises his option. According to the SoFi.com website, it is a risky proposition that is not for all investors. That is because the asset being bought or sold is not the stock itself, but the right to buy or sell it.
Option contracts are usually for 100 shares of stock. Risk is incurred because the stock may increase or decrease in value. That trait is called volatility. Stocks may have historical volatility or intrinsic volatility.
One thing that affects stock volatility is the number of shares available for trading. That is called a stock float. Sometimes investors are limited in the number of shares they can sell. Stocks with smaller stock floats are usually more volatile.
Types of Options
There are two basic types of stock options. Call options are contracts that give the buyer the right to acquire the stock within a certain timeframe (which could be days or years) for a specified price (the strike price).
For instance, a trader might buy an options contract for a certain stock at $10 a share. The contract duration could be one year. If at the end of 364 days, the stock value has increased to $100 a share, the options holder has the right to buy 100 shares at $10 a share. His profit at that point would be $9,000.
Put options give the seller the option to share the stock at the strike price within a specified time. This may mitigate risk because if the stock increases in value, he is not forced to sell it at the strike price, so he can only lose the money he spent on the option.
How Options Trading Works
SoFi’s options trading guide says both put and call options hinge upon whether the trader exercises the option during the time frame stipulated in the contract. Someone buying a call contract hopes that the value of the stock will increase. If the trader has set a price of $10 per share for 100 shares, and the stock value increases, the buyer can get the stock for the agreed-upon price.
That is because he has paid the contract price for that option. A trader who buys a put contract hopes the value will go down. If the stock value drops, the trader can still sell at the strike price. If he chooses not to, he forfeits the price he paid for the option.
Advantages and Risks
Obviously, buying an option is less risky than purchasing the actual stock. That factor can help investors protect their portfolios from the rapid fluctuations in stock values.
If, however, the stock doesn’t perform as you thought it might and you choose not to exercise your option, you forfeit the premium (the price you paid for the options). People who trade in a lot of options can potentially lose a lot of money in the forfeit of premiums.
Traders may have many strategies to profit from options trading or mitigate losses. The simplest is to buy both a call option and a put option on the same stock at the same strike price. If the stock rises in value, they make money buying at a lower rate. If it decreases, they make a profit selling at the higher strike price.
This explanation of stock options is abbreviated. People who want to begin buying options should study a guide such as the options trading guide from SoFi to equip themselves with the necessary knowledge to use this important investment tool.