Options are a loan contract given to an investor or investors so they may leverage their financial position to a greater level. An options contract allows the investor to purchase a large volume of securities on 'margin' at a proportionally lower but representative price with the knowledge that (s)he may have to pay back the financial institution if the option does not perform the way the investor intended.
Unlike regular stock trading, options are traded with the intent and choice of either selling or buying the underlying securities within the options contract. In other words, the options trader has an option or choice regarding how money is intended to be made i.e either a rise or decline in the security. There is a fair amount of financial lingo associated with options trading but three of the more important and fundamental terms are strike price, expiration date and exercise.
Strike price
Options are traded as 'calls' or 'puts' a call option is purchased with the intent to purchase the stocks in the option. This future purchase price is called the strike price and is different from the option price. If the price of a stock goes up during the term of the option, the trader or investor may get a deal having locked into a lower strike price. An option strike price may also be a sell price in the case of a 'put'.
Short put option
Source: 'Gxti'; CC By-S.A. 3.0
This is also called short selling as the trader is betting the stock will go down during the term of the option. For example, if a trader buys a put option of Pear Inc. with a strike price of $55.67 and the price of Pear Inc. drops during the term of the option, the trader can then sell the option at the strike price of $55.67 and make a profit if the option cost was lower than the strike price.
Expiration date
Options are purchased with time limits. Like a bottles of milk, options expire at a set date in the future. This time limit is often in increments of 30 days. For example, if an option is purchased at the beginning of the month, that option will likely expire at the end of that same month. However options can be bought with expirations several months into the future.
The usual extent of options is four months but some options have what are called 'LEAPS' which allow options contracts to exist for more than four months. For example, if it is July now, a July option can be bought with an expiration of July 31 or an August option can be bought with an expiration in August. If LEAPS are available for the option, a contract for November should also be available.
Exercising an option
The terms of an option require the buyer to either exercise, continue or cover an option. When exercising a call option for example, the investor buys in at the predetermined strike price stated in the option. If the price of a stock has increased enough half way through the options term, it is a calculated decision by the investor to exercise the option before its expiration. If the price goes down, the trader can either wait and hope the price will go back up or cover his or her position by exercising at a loss. Naturally, this is not a favorable scenario for an options trader.
Options are a leveraged form of securities trading and make possible high volumes of exchange. Options can be traded for stock, commodities and currency markets. Options are bought ahead of time based on the traders anticipation of either an increase or decrease in the actual price of the security being traded and not the option price itself.
Options contracts are separate from the underlying securities which they represent in the sense that the contract is a unique financial instrument in and of itself. In the case of stock options, a brokerage firm would offer a margin to the investor so they may utilize the options market. While there are quite a few intricacies and terms associated with options trading, three of the most important aspects of options are the strike price, expiration date and the exercising of the options contract.
Sources:
1. http://www.investopedia.com/terms/s/strikeprice.asp
2. http://en.wikipedia.org/wiki/Option_(finance)
3. http://www.investopedia.com/articles/optioninvestor/03/090303.asp
4. http://invest-faq.com/articles/deriv-option-basics.html
5. http://en.wikipedia.org/wiki/Exercise_(options)
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