What is a Stock Option?

What Is A Stock Option?

Exploring the Anatomy of a Stock Option Contract.

A stock option is a standardized contract concerning the purchase or the sale of a specific security, at a predetermined price, on, and perhaps before, a specified date.

Each option, at its most basic level, is simply a contract that gives the holder of the option the right to buy or sell a specific security. That security might be a stock, an index, or a futures contract.

Option Type: Call Option versus Put Option

Options come in one of two flavors: calls and puts.  An option may be bought, or it may be sold, and with the exception of exercising one's rights under the contract those are the only things that can be done with an option.  Depending upon whether you are buying or selling, calls or puts, you will obtain and incur differing rights and obligations.

As the buyer of a call option, you would pay an option seller a cash premium in exchange for the right to purchase the underlying security at the option's strike price, on or before the option's expiration date. The seller of a call option collects a premium for the sale, but must stand ready to deliver the underlying security to the option holder if called upon to do so.

Conversely, the put option buyer acquires the right to sell the underlying security. The put option seller must stand ready to take purchase the underlying security from the option buyer at the strike price of the put option, should the holder of the put option choose to exercise their rights under the contract.

It is important to understand that there are always two sides to an option transaction.  The buyer who is acquiring rights and the option seller who is incurring an obligation in exchange for a cash premium.

Option Strike Price

Each option contract carries a specified price at which the underlying security is to be bought or sold. This "strike price," as it is called, is the price at which the owner of the call may purchase the underlying security and the price at which the owner of the put option may sell the underlying security.

Those who have sold the options are obligated to buy, or sell, at the strike price.  This price is known when the opening transaction takes place and cannot later be changed.  This provides both sides of the tranaction with certainty as to the price they are able to purchase or sell the underlying stock.

Option Expiration Date

Options have finite life spans. Each option carries an expiration date. Stock option contracts have been standardized and uniformly expire on the Saturday following the third Friday of their designated expiration month. For example, a December option will expire on the Saturday following the third Friday in the month of December.

If an option position remains opened on the expiration date, it will expire worthless. Most brokers will automatically exercise an option contract for their clients, if the underlying security's price exceed the strike price of a call option or is lower than the strike price of a put option.

It is not necessary to hold an option position until the expiration date, however.  An option buyer who owns an option may sell that option, thereby closing their position.  Option sellers can close their "short" option position by executing a "buy" order.  Because option contracts are standardized it is not necessary for the closing transaction to be carried out with any particular person.

Option Contract Review and Example

The buyer of a call option has the right, but not the obligation, to buy the underlying security at the specified strike price. The seller of the call option has the obligation, but not the right, to sell the underlying security at the specified strike price.

Assume that today is March 1st and the stock price of XYZ Company is currently at $30 per share. You are bullish on the stock, believing that in the next week the company's share price will climb to $35 per share.

Based upon your belief, you buy an April $30 XYZ Call option.  This provides you with the right to buy XYZ stock at $30 between now and the Saturday following the third Friday in April.

If XYZ does trade up to $35 per share, you may exercise your rights to buy the stock at $30. If the stock price failed to climb, your option would expire worthless unless closed out prior to the expiration date.

The buyer of a put option has the right, but not the obligation, to sell the underlying security at the specified strike price. The seller of the put option has the obligation, but not the right, to buy the underlying security at the specified strike price.

Now, assume that it is now April 15th and that XYZ company has increased in price to $28 per share. You remain bullish on the stock and sell the May $27.50 XYZ Put, receiving a $1.00 premium for the sale. You are now obligated to buy XYZ stock at $27.50 per share, if the put contract is exercised.

By the May expiration date, the stock has traded to $28.75 and the put option expires worthless. Your position is now closed and any obligation is ended. You keep the cash premium received from the sale.

About The Author

Christopher Smith

http://www.linkedin.com/in/theoptionclub