What the Hell is a Stock option?

A 'stock option' is a contract between two parties giving the buyer (also known as the 'taker') the right, but not the obligation, to either buy or sell a specific quantity of shares at a pre-agreed price (known as the 'strike price' or 'exercise price') by a certain future 'expiry' date. There are two different types of options that can be traded, known as 'call options' and 'put options'.

For an option contract to be traded there must be both a 'buyer' and a 'seller' involved in the transaction. The buyer pays an upfront amount; known as the 'premium', to the option seller (the seller is also often referred to as the 'writer' of the option contract). In the Australian market, each option contract typically covers 1,000 of the underlying shares and the premium is expressed as a specific number of cents per share.

Buying Call Options:

A Buyer of Calls aims to profit by a rising stock price, as they have locked in a "purchase" price at which they can buy the underlying shares at whenever they wish up until the expiry date.

Selling Call Options:
A Seller of Calls is committed to selling the underlying shares at a pre-agreed price, no matter how high they might get. In exchange for this potential obligation, they receive an upfront premium.

Buying Put Options:
A Buyer of Puts can profit by a decreasing stock price, as they have locked in a "selling" price at which they can sell the underlying shares up until the expiry date.

Selling Put Options:
A Seller of Puts is committed to buying shares at a pre-agreed price, no matter how low they might get. In exchange for this obligation, they receive an upfront premium.

OK now for some examples to show you a few basic ways of buying and selling put and call options:

So let's say you've found a share that you think will increase in price and think you can make a profit if you are right. Rather than buy the actual shares, you might decide to purchase some Call Options. This will enable you to spend much less capital but can still get the benefit from the rise in the share price.

Maybe you own 1,000 shares in a company and the share price appears to be flat and going nowhere, so you decide to sell a Call Option against those shares. This will earn you a premium income. This way, even if the shares are right where they started when the Expiry Date comes along, you've made a small amount of money.

Your share has gone though a recent rise and the share price seems to have flattened out and you are now concerned that your share price might fall. You decide to purchase some Put Options, knowing that if the shares do fall, you've locked in a selling price and now have a form of "insurance" on your shares to protect you from losing too much.

There's a share you'd be happy to own, but only if it was at a lower in price, so you decide to sell some Put Options at a Strike Price just below the current market price and you'll receive a premium upfront. When the Expiry Date comes along, if the share is above the Strike Price you won't have to buy the stock and will be able to retain the premium. If the share is under your Strike Price, you'll be Exercised and hence forced to buy the shares at the pre-agreed price.

Here a list of some important terms which you will find are regularly used when referring to options:

All Ordinaries Index:
The main Australian stock market price index which tracks the change in the Total market value of a range of stocks.

Ask/Ask Price:
The price a trader or market maker is willing to accept for selling a stock or option. Also referred to as the offer price.

Assignment:
When an option holder exercises the contract an option writer is selected to fulfill the obligation. The option writer is required to sell (in the case of a call) or purchase (in the case of a put) the underlying stock at the specified strike price.

At-Market or At-the-Market:
An order to buy or sell a stock or option at the current market price. Also referred to as a Market Order.

At-the-Money (ATM): An option whose strike price is equal to (or close to) the current price of the underlying stock.

At-the-Opening Order:
A market order that requires it to be executed at the opening of the market or of the trading of the security or else it is cancelled.

ATR Stop:
A stop set to activate if price drops a multiple of its Average True Range.

Australian Stock Exchange (ASX): Six Australian trading floors are linked through the Stock Exchange Automated Trading Systems (SEATS). Administrative headquarters are in Sydney.

Avoidable Risk: Risk items that can be eliminated through management. Bearish Someone is said to be a bear or be bearish if they think a stock or the market is going to trend down over a particular time frame. Also a negative or pessimistic outlook.

Bear Market: A declining stock market, usually over a prolonged period. Also, a market in which prices of a certain group of stocks are falling or are expected to fall.

Bear (or Bearish) Spread:
One of a variety of strategies involving two or more options (or options combined with a position in the underlying stock) that will profit from a fall in the price of the underlying stock.

Bear Call Spread:
The simultaneous writing of one call option with a lower strike price and the purchase of another call option with a higher strike price.

Bear Put Spread:
The simultaneous purchase of one put option with a higher strike price and the writing of another put option with a lower strike price.

Bid/Ask Quotation:
The latest bid and ask prices for a stock or option contract.

Bid/Ask Spread:
The difference in price between the latest available bid and ask quotations.

Bid Price:
The highest price a potential buyer or market maker is willing to pay for a particular stock or option.

Blue Chip Stock:
A term derived from poker where blue chips held the most value. Blue chips in the stock market are those stocks that have the most market capitalization.

Broker:
An individual or firm who is paid a commission for executing stock market orders on behalf of their customers. A broker at a brokerage firm deals directly with customers. A floor broker on the trading floor of an exchange actually executes someone else's trading orders.

Brokerage:
The commission brokers charge for executing stock market orders. Based on either a schedule of rates or a percentage basis.

Bullish:
Someone is said to be a bull or be bullish if they think a stock or the market is going to trend up over a particular time frame. Also a positive or optimistic outlook.

Bull Market:
A rising stock market, usually over a prolonged period. Also, a market in which prices of a certain group of stocks are rising or are expected to rise.

Bull (or Bullish) Spread:
One of a variety of strategies involving two or more options (or options combined with an underlying stock position) that will profit from a rise in the price of the underlying stock.

Bull Call Spread:
The simultaneous purchase of one call option with a lower strike price and the writing of another call option with a higher strike price.

Bull Put Spread:
The simultaneous writing of one put option with a higher strike price and the purchase of another put option with a lower strike price.

Buyer:
If you purchase an option contract, regardless of whether you are opening or closing a position, you are a buyer.

Buy-Write:
A covered call position in which stock is purchased and an equivalent number of calls written at the same time. This position may be transacted as a spread order, with both sides (buying stock and writing calls) being executed simultaneously. Refer also Covered Call.

Call Option:
A contract that gives the holder of the option the right, but not the obligation, to buy a certain quantity of shares of an underlying stock from the seller or writer of the option at a specific price (strike price) up to a specified date(expiration). For the writer of a call option, the contract represents an obligation to sell the underlying stock if the option is assigned.

Contract:
A call or put option issued by the OCC.

Contract Size:
The amount of the underlying stock covered by the options contract. One stock option contract consists of 100 shares (USA) or 1000 (Australia and UK) ? unless adjusted for a special circumstance like a stock split or a stock dividend.

Cover:
To close out an open position. This term is used most frequently to describe the purchase of an option or stock to close out an existing short position.

Covered Call:
The selling or writing of a call option while holding the underlying stock. By receiving a premium, the writer seeks to gain additional return on the underlying stock or gain some element of protection from a decline in the value of that underlying stock.

Covered Cash-Secured Put:
An option strategy in which a put option is written against a sufficient amount of cash (or T-bills) to pay for the stock purchase if the short option is assigned.

Covered Combination:
An option strategy in which a call and a put with the same expiration, but different strike prices, are written against the underlying stock. In reality, this is not a fully covered strategy because assignment on the short put would require purchase of additional stock.

Covered Option:
An open short option position that is fully offset by a corresponding stock or option position. That is, a covered call could be offset by long stock or a long call, while a covered put could be offset by a long put or a short stock position. This insures that if the owner of the option exercises, the writer of the option will not have a problem fulfilling the delivery requirements.

Credit spread:
A spread strategy that increases the account's cash balance when it is established. A bull spread with puts and a bear spread with calls are examples of credit spreads.

Debit Spread:
An option spread strategy that decreases the account's cash balance when it is established. A bull spread with calls and a bear spread with puts are examples of debit spreads.

Decay:
A term used to describe how the theoretical value of an option erodes or reduces with the passage of time. Time decay is specifically quantified by theta.

Diagonal Spread:
A strategy involving the simultaneous purchase and writing of two options of the same type that have different strike prices and different expiration dates.

Downside:
The potential for prices to move down. Also, the potential risk one takes with directional trading.

Exchange Traded Options (ETOs):
Options issued by stock exchanges, not companies. Derived from stocks.

Exercise:
To exercise an option contract by buying (in the case of a call) or selling (in the case of a put) the underlying stock at the Strike Price.

Exercise Price:
The price at which you may buy the underlying stock, if you hold a call, or sell the underlying stock, if you hold a put. Also referred to as the strike price.

Expiration:
Last day on which an option can be traded. The date after which an option is no longer valid and you can no longer exercise it.

Extrinsic Value:
The price of an option less its intrinsic value. Same as time value.

In-the-Money (ITM):
If you were to exercise an option and it would generate a profit, it is known as being in-the-money. In other words it has intrinsic value. A call option is ITM if the strike price is less than the current price of the underlying stock. Puts are ITM when the strike price is above the current stock price.

Intrinsic Value:
The value of an option if it were to expire immediately. OTM and ATM options have no intrinsic value. For ITM options, the intrinsic value is the difference between the strike price and the current stock price.

Leverage:
Using a smaller amount of money to control an investment of greater value. For example, options provide greater leverage than shares.

Liquidity / Liquid Market:
A trading environment characterized by high trading volume, a narrow spread between the bid and ask prices, and the ability to trade larger sized orders without significant price changes. Liquidity in stocks is measured by trading volume and in options is measured by what is known as open interest.

Margin:
When you purchase stock through your broker you can do so using cash or margin. Most brokers offer a margin facility where you only have to put up a portion of the cash required (typically 50%). The balance of the funds are borrowed from the broker.

Margin Account:
A traders account in which a brokerage firm lends the customer part of the purchase price of securities.

Margin Call:
If the price of stock that a trader has bought falls below a set proportion of the initial cash investment (for example 75%) they will receive a margin call. The trader is then required to either deposit additional funds into their account or sell some shares to cover the shortfall.

Margin Requirement:
The minimum equity required to support a position where margin is used.

Market Depth:
A summary of current bids and ask prices on a particular stock or option. An indication of liquidity.

Market-Maker:
An exchange member on the trading floor who buys and sells stocks or options for his or her own account and who has the responsibility of making bids and offers and maintaining a fair and orderly market.

Money Management:
Strategies used to ensure a trader's survival and profitability. Key elements are (a) capital preservation; (b) cutting losses; and (c) taking profits.

Naked Call:
The writer of the option does not hold the shares of the underlying stock represented by the option.

Naked Option:
A short option position that is not fully covered if notification of assignment is received.

Naked Put:
Writer of a put option not short the underlying stock. Out-of-the-Money (OTM) An option whose exercise price has no intrinsic value is know as out-of-the money. A call option is OTM if its strike price is above the current stock price. Puts are OTM when the strike price is below the stock price.

Paper Trading:
Simulated trading but without putting money into the market.

Premium: Price a buyer pays to an option writer for granting an option contract.

Rolling: A trading action in which the trader simultaneously closes an open option position and creates a new option position at a different strike price, different expiration, or both. Variations of this include rolling up, rolling down, rolling out and diagonal rolling.

Share:
One unit of ownership of stock.

Spread:
An options strategy where you hold two or more simultaneous positions. Also refer to Bid-Ask Spread.

Spread Rolls:
Using a spread order to bridge the closing of one position and the establishment of a new one.

Stocks:
Units of ownership of public companies.

Time Decay:
The decline in value of an option as the expiration date approaches.

Time Spread:
An option strategy which involves the purchase of a longer-term option (call or put) and the writing of an equal number of nearer-term options of the same type and strike price. Also known as a calendar or horizontal spread.

Unavoidable Risk:
Risk items that cannot be eliminated but can still be managed.

This is just an introduction to world of exchanged traded options and I hope this may have sparked an interest inside you to explore the world further.

Author Raymond Heye has been trading options and found all kinds of secrets that he is willing to share with others though several articles he has written To learn more, visit: http://www.ourmoneyfarm.com

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How income from stocks and mutual funds are taxed for an individual  Moneycontrol.comCapital gains from transfer of unlisted share are considered as STCG where period of holding is less than or equal to 24 months, and LTCG when holding period ...
Is it time to switch to index mutual funds?  Economic TimesBy Rishabh Parakh It is one of the hottest topics debated these days: is it time for mutual fund investors to switch to passively-managed index funds from their ...
How concentrated is your mutual fund portfolio?  LivemintA concentrated portfolio can backfire badly if the fund manager's strategy goes wrong.A portfolio with few stocks can fall sharply if share prices of most stocks in ...
Stay away from stock tips  LivemintIf taming the stock market was easy, everyone would do it.Losing money in market is real and facing volatility is part of the deal.
Value mutual funds have given good returns over long term but can underperform in short term  Economic TimesOver the years, the benefits of value investing have been espoused by several market gurus and fund managers. Discussions around this investing philosophy ...
Equity mutual funds are offering negative returns. What should investors do?  Economic TimesAll equity mutual fund categories have been offering negative average returns in the last one year. Small cap and mid cap schemes were hit the most, with ...
Should investors with very long term horizon always pick small cap mutual funds?  Economic TimesMutual fund investors assume that their risk taking ability goes up if they have really long investment horizon.
Should you invest in algorithm-based quant mutual funds?  Economic TimesQuant funds work on a data-driven model that relies on a mix of parameters and algorithms to identify the right stocks at the right time. But can they beat actively ...
Can mutual funds give multibagger returns like stocks?  Economic TimesStocks can be multibaggers. They can offer extraordinary returns in a very short period. Can mutual funds ever do that? This was a question thrown at Rajeev ...
Best mutual funds to invest for 10 to 15 years  Economic TimesIf you have any mutual fund queries, message on ET Mutual Funds on Facebook. We will get it answered by our panel of experts.
Stick to MFs if you lack knowledge on stocks  LivemintWhile equity is surely the way going forward considering your age and the financial goals, how you buy in equity is important.Direct stocks work very well if done ...
Understand difference between large-cap, mid-cap and multi-cap mutual funds when investing  Economic TimesExperts say large and mid cap mutual funds have carved a niche for themselves in portfolios.
Govt tweaks rules, increases limit to disclose investment in stocks, mutual funds for employees  Economic TimesNew Delhi: The Centre has increased the over 26-year-old monetary limit on disclosure of investment in shares and mutual funds by employees to six months of ...

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