What is an Stock Option?
While a stock option may sound complicated and appropriate only for sophisticated investors, they are quite easy to understand and actually quite commonly used in everyday life – although they are called by different names. In fact, we’re sure that everyone reading this article has used a call or put option at one time or another. If you don’t believe it, keep reading!
Stock Options are simply agreements between two people to buy and sell stock. Options (from your employer) give you the right to buy a specific number of shares of (your) company’s stocks during a time and at a price that your employer specifies.
Investors like to trade options in order to speculate that the price of the stock will go up or down. They trade calls and puts.
What is call option or put option?
A call option gives the owner the right, not the obligation, to buy stock at a specific price over a given period of time. In other words, it gives you the right to “call” stock away from another person.
A put option, on the other hand, gives the owner the right, not the obligation, to sell stock at a specific price through an expiration date. It gives you the right to “put” the stock back to the owner. Options only convey rights to buy or sell stock. If you own an option, you do not get any of the benefits that come with stock such as dividends or voting privileges. Options are simply agreements between two people to buy and sell stock.
You’re probably thinking that you’ve never used anything remotely close to a call option but think about the following:
A pizza coupon? Yes, that’s really all a call option is.
The above coupon gives the holder the right to buy one pizza. It is not an obligation. You use the coupon only if you choose to do so. Notice we’ve been saying that the owner has the right – not the obligation – to buy stock (with a call) or sell stock (with a put). In other words, it is your option to choose what to do with it and that’s where these assets get their name.
Put options, on the other hand, can be thought of as an insurance policy. Take, for example, your car insurance. When you buy an auto insurance policy, you really hope that you will not wreck your car and that the policy will “expire worthless.” However, if you should total your car, you can always “put” it back to the insurance company in exchange for cash. Put options allow the holder to “put” stock back to someone else in exchange for cash. It is important to remember that buyers of options, whether calls or puts, have rights, not obligations.
Sellers of options, on the other hand, have obligations. They sell option premium and therefore have an obligation to fulfil the contract if the call or put holder decides to use their option. If you sell a call option, you have the potential obligation to sell stock. If you sell a put option, you have the potential obligation to buy stock. You have a “potential” obligation since you do not know whether or not the buyer will use the option. Notice that the buyers and sellers are on opposite sides of the deal. The call holder has the right to buy while the call seller has the obligation to sell. This arrangement is necessary in order for it to work. First, we have a buyer matched with a seller of the call. Second, if the call buyer wishes to buy stock, we know the deal will go through since the call seller has the obligation to sell stock. The put buyer has the right to sell stock, while the put seller has the obligation to buy stock.
Needless to say is that insurance companies are very rich. That is because they sell a lot of insurances. Why do we prefer to sell options and not buying stocks? Find out how to sell option premium and make decent profits.
By combining selling puts and buying puts together you create low risk trades put spread. You can also sell calls and buy calls to to create a low risk call spread.