What Are Stock Options Essay, Research Paper

You buy or trade stocks, bonds and mutual funds. Some investors use options on stocks or cash indexes to protect and insure the value of their portfolios. A major advantage of options is their flexibility.

 You can protect stock holdings from a decline in market price

 You can increase income against current stock holding

 You can prepare to buy a stock at a lower price

 You can position yourself for a big market move even when you don’ t know which way prices will move

 You can benefit from a stock price rise without incurring the cost of buying the stock outright

Stock options work much like stocks, options can be used to take a position on the market in an effort to capitalize on an upward or downward market move. Unlike stocks, however, options can provide an investor the benefits of leverage over a position in an individual stock or basket of stocks reflecting the broad market. At the same time, options buyers also can take advantage of predetermined, limited risk. On the other hand, options writers assume significant risk if they do not hedge their positions.

The most basic stock options are buying calls and buying puts. An option is the right, but not the obligation, to buy or sell a stock (or other security) for a specified price on or before a specific date. A call is the right to buy the stock, while a put is the right to sell the stock. The person who purchases an option, whether it is a put or a call, is the option “buyer.” the person who originally sells the put or call is the option “seller.”

Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy or sell a particular asset at a fixed price (the strike price) for a specific period of time or until expiration. To the buyer, an equity call option normally represents the right to buy 100 shares of underlying stock, whereas an equity put option normally represents the right to sell 100 shares of underlying stock. The seller of an option is obligated to perform according to the terms of the options contract-selling the stock at the contracted price for a call seller, or purchasing it for a put seller-if the option is exercised by the buyer. All option contracts trade on U.S. securities exchanges are issued, guaranteed and cleared by the Options Clearing Corporation (OCC). OCC is a registered clearing corporation with the SEC and has received ‘AAA’ credit rating form Standard & Poor’s Corporation. The ‘AAA’ credit rating corresponds to OCC’s ability to fulfill its obligations as counter-party for options trades.

The price of an option is called its “premium.” The potential loss to the buyer of an option can be no greater than the initial premium paid for the contract, regardless of the performance of the underlying stock. This allows an investor to control the amount of risk assumed. On the contrary, the seller of the option, in return for the premium received from the buyer, assumes the risk of being assigned if the contract is exercised.

In accordance with the standardized terms of their contracts, all options expire on a certain date, called the “expiration date.” For conventional listed options, this can be up to nine months from the date the options are first listed for trading. There are longer-term option contracts, called LEAPS, which can have expiration dates up to three years from the date of the listing. American-style options (the most commonly traded) and European-style options possess different regulations relating to expiration and the exercising of an option. An American-style option is an option contract that may be exercised at any time between the date of purchase and the expiration date. An European-style option (used primarily with cash settled options) can only be exercised during a specified period of time just prior to expiration.

With call options the buyer of an equity call option has purchased the right to buy 100 shares of the underlying stock at the stated exercise price. The buyer of one XYZ June 110 call option has the right to purchase 100 shares of XYZ at $110 up until June expiration. The buyer may do so by filing an exercise notice through his broker or trading firm to the Options Clearing Corporation prior to the expiration date of the option. All calls covering XYZ are referred to as an “option class.” Each individual option with a distinctive trading month and strike price is an “option series.” The XYZ June 110 calls would be an individual series.

The buyer of a put option has purchased the right to sell the number of shares of the underlying stock at the contracted exercise price. The buyer of one ZYX June 50 put has the right to sell 100 shares of ZYX at $50 any time prior to the expiration date. In order to exercise the option and sell the underlying at the agreed upon exercise price, the buyer must file a proper exercise notice with the OCC through a broker before the date of expiration. All puts covering ZYX stock are referred to as an “option class.” Each individual option with a distinctive trading month and strike price is an “option series.” The ZYX June 50 puts would be an individual series.

If you anticipate a rise or fall in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish). If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value. On the other hand, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential. Purchasing options offer you the ability to position yourself accordingly with your market expectations in a manner such that you can both profit and protect with limited risk.

Bullish Theory

Buying an XYZ July 50 call option gives you the right to purchase 100 shares of XYZ common stock at a cost of $50 per share at any time before the option expires in July. The right to buy stock at a fixed price becomes more valuable as the price of the underlying stock increases.

Bearish Theory

Put options may provide a more attractive method than shorting stock for profiting on stock price declines. The most you can lose is the cost of the option. If you short stock, the potential loss, in the event of a price upturn, is unlimited. Another advantage of buying puts results from your paying the full purchase price in cash at the time the put is bought. Shorting stock requires a margin account, and margin calls on a short sale might force you to cover your position prematurely, even though the position still may have profit potential. As a put buyer, you can hold your position through the option’s expiration without incurring any additional risk.

Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing options, to earn premium income.

Options involve risk and are not for the lesser risk taker. An investor who desires to utilize options should have well-defined investment objectives suited to his particular financial situation and a plan for achieving these objectives. The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies.