Option Basics and Types

Some investors tend to sign option contracts, which include the right to buy or sell securities when a certain price is reached. This is done when a particular date is reached or even before this date. Options give owners the right to do so, but they are not obliged to sell or buy a security under these conditions.

Option Basics

The following are some basic characteristics of options:

1. Options are sold in lots of 100. This means that if an option is sold at $3, then you will have to pay $300 to buy options.

2. Options are identified by their date of expiration and the strike price (also known as exercise price). The latter represents the price that is quoted in the option contract. So, if you read "ABC May 30 Call", then this means that this is a call option that will expire in May and its strike price is $30.

   As a rule options expire on every third Friday of the month. If this Friday is a holiday, then the expiration date will be on Thursday. So, the expiration date represents the month in which the option is expected to expire by contract.

Types of Options

Generally there are two major types of options. The latter are traded just as regular stocks.

• Call Options

  Under the conditions of call options, owners have the right to buy a security after a particular price has been reached. This should be done at a particular date or before it.

  Options have expiration date. So, investors usually buy call options if they expect that the price of the stock is about to go up. In order to clarify the idea, consider the following example.

  John anticipates that the stock price of company ABC is about to increase. The current stock price is $30. So, he decides to purchase a call option, which gives him the right to purchase 100 shares of the stock during the following 60 days. The cost of the option is $100. Thus, if the price really rises let's say to $35 before the option expires, then John will benefit a profit of $4 per share.

  Another tactic that John may undertake is to trade the option and enjoy the profit without even purchasing the share of stock.

  However, if the price of the stock falls, you will incur a loss of $100, which represents the cost of the option.

• Put Options

  Under the conditions of put options, owners have the right to sell a security after a particular price has been reached. This should be done at a particular date or before it.

  Put options are generally preferred if the price of the stock is expected to fall before the option expires.

  So, if an investor expects that the price of the stock is about to fall, s/he can short the stock. This is done by purchasing a put option giving the investor the right to sell shares at a certain price. Thus, when the price of the stock falls, the investor can purchase stock on the open market at the new lower price and exercise the put option selling the stock at the higher price.

  Shorting the stock, however, carries a certain degree of risk and should be exercised with caution.

Finally, if you are a beginner investor, then it may be not a good idea to use options as an investment tool, since they have many complexities.

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