Understand Stock Options Financial Derivatives


          Financial Derivatives, of which stock options are a part are some of the most advanced instruments of the whole stock market world. Financial derivatives are similar in a sense to derivatives in calculus or math in that they both follow or change with the underlying security or equation that they describe. Financial derivates are made up of contracts such as futures contracts, equity contracts called options or swaps. Futures contracts are contracts based on the commodities markets such as gold, or wheat while options are contracts with respect to stocks traded in the stock market. The article here will deal only with equity or stock options. Read the information below to help you understand stock options and what investors may do with them.

Step 1

Stock options or equity options are basically contracts from one party to another that offer the ability (for a small fee) to purchase or sell a certain number of shares of a stock at a specified price called the “strike” price within a certain time frame designated by the expiration date of the option contract. Stock options are offered on many different stocks on the major stock indices. One of the best ways to trade options is to open an online brokerage account that is specifically tailored to options traders.

Call Options

          Calls are contracts written to buy a certain stock at a certain price by a certain deadline. Generally calls are purchased by investors who want to own a certain number of shares of stock because they think the stock will rise. However they do not want to assume the monetary liability of purchasing all of those shares of stock outright from the beginning in the event that the stock plummets or lowers in price. By paying a small premium to buy a stock option instead of buying the stock itself, the person can choose to exercise that option at a later date if the underlying stock does in fact rise in price above the strike price. The person will then purchase the pre-designated number of shares of stock. At that point the stock is theirs at the strike price and they can do with it whatever they choose such as holding the stock or selling it for a profit.

Now, stock options calls contracts are written in the following manner. Each contract stands for or controls 100 shares of underlying stock. So if you purchase 5 contracts for a stock we’ll call XYZ then those 5 contracts are giving you the ability to purchase 500 shares of XYZ should you choose to exercise the call option. The call options will be bought at a certain strike price and expiration date. For this example we’ll say they are 5 XYZ June 50 Call contracts. Suppose you just purchased these contracts and it is April now. These contracts are giving you the ability to purchase 500 shares of stock of the company XYZ for 50 dollars a share by the deadline of June 19th. Generally for the given contract month the stock options will expire on the Saturday of the 3rd week or following the 3rd Friday of the month. If the stock does not rise to the strike price or above by the expiration date then your options will expire worthless and you will not take possession of the stock. This can help you save quite a bit of money. For example suppose XYZ was trading at 45 dollars a share when you purchased the June 50 calls. By June 19th at expiration let’s say that XYZ was now trading at 30 dollars a share. Since your contract does not execute and you did not have to purchase the shares of stock you saved yourself from owning 500 shares of a stock that dropped in price by 15 dollars a share from the day you purchased the contracts. You will only lose the money or premium you paid for the contracts which is so small compared to the loss you would have taken if you had bought the stock outright that day.

Put Options

Put options can be thought of as the opposite of call options. Whereas call options represent the ability to purchase shares of stock at a designated price, put options represent the ability to sell shares at a certain price. When you exercise a put option whose stock has fallen below its strike price then you automatically sell shares at the current price, which is done for you by your brokerage firm with their own shares. The money is then deposited into your account. You then have the obligation to buy back the shares to close your position at any date from that point forward. Sometimes brokerages will force you to close your position early. With this trade you are hoping for a drop in stock price below the strike price of the Put contract. This way when the shares are sold for you at the strike price and you buy them back at a lower price you have made the profit of the difference in price.

Different Ways to Trade Options

In addition to exercising your options contracts and going through with the corresponding buying or selling of stock for calls and puts there is another way that an investor can trade stock options. You can also buy the call and put contracts and sell the contracts themselves back on the open market before the expiration date is reached. You can make money off of the fluctuation in pricing of the options contracts themselves. For example an underlying positive move in the stock will cause a call option contract to rise in value and a put option contract to lower in value. A fall in the underlying security will have the opposite effects. Many people make money off of trading the option equity contracts themselves in this manner. There are also other factors that can cause stock options to change in value such as the volatility of the stock and the time decay factor which is a factor that causes stock options to lose intrinsic value the closer the option gets to expiration.

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