Stock options are financial instruments that provide traders a great opportunity to make money by trading on the open market. Stock options are essentially contracts that a buyer and seller agree upon pertaining to an underlying asset. With stock options, this asset is stock.
For example, 300 shares of a company’s stock would qualify as an underlying asset. Generally speaking, the underlying asset will be all one company (so 300 shares of the same company as opposed to different amounts from different firms.) Additionally, the shares stick together, so to speak. If you exercise the option, you are agreeing to act on all of the 300 shares. But what does “exercise” even mean? That as well as other questions will be answered below as we discuss stock options basics.
With a call option, the buyer purchases from the seller the right but not the obligation to buy the underlying asset at a predetermined price known as the strike price. The two parties agree on a strike price that will remain until the option is either exercised or it expires.
If the buyer elects to exercise the option, they will purchase the asset for the strike price regardless of the asset’s real market value. This provides a valuable benefit to traders as it can allow them to purchase a collection of stock at a discounted rate. The result is a net profit. You can either sell the stock at the market rate. Alternatively, instead of exercising you can simply sell the option to another trader, which will provide the same profit.
It is important to understand that options have expiration dates. This expiration date is the last date you can exercise the option. If it is not lucrative to exercise (the market value is lower than the strike price,) then it is easy to simply let the option expire. There is, after all, no legal obligation to exchange the stock. So what is the risk associated with a stock option investment?
Your investment in a stock option is known as the premium. It is essentially the expense of the option and must be paid by the buyer. One good thing is that risk is essentially reserved to simply the premium. It is still ideal, though, to select options that will not require a loss of principal.
Hopefully this article on stock options basics will help you understand stock options. It is important when trading options to truly understand the complexities of the market and how to strategically manage your portfolio. Make sure to be prepared before trading, but remember that opportunity does exist in responsible investment.
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