Question:

What are stock options?

The difference between stocks and stock options

Unlike stocks, options have a limited life. If an expected move does not immediately occur, a stock investor can say, "I'll give it another week." This is not always true with options trading. Each option has a set expiration date. At expiration, an option is either worth the difference between its strike price and the current stock price, or it's worthless.

There are a couple of key factors to keep in mind when dealing with the limited life of options. The first key factor is the understanding that an option's value depends on the ability to correctly predict both the direction and timing of a move in the price of the underlying stock. The first variable, direction, is easily understood. If the expectation is that the underlying stock price will go up but instead it goes down, the investor loses money. (However, an options investor could earn money if the expectation is that the underlying stock price will drop and the price does drop.) The second key variable in options trading is the timing of the direction. For instance, the holder (buyer) of a Dun & Bradstreet May 35 call is guaranteed the right to buy 100 shares of the stock at $35 per share at any time before the option's May expiration, even if the stock rallies to $40, $50, or even $70 per share. However, it costs more to pay for a July 35 call than a May 35 call, because of the additional time, and therefore, improved likelihood, that the stock will rally above the price of $35 per share.

Dividends are another key difference between stock and option trading. Dividends do not represent a change in value to the holder of a stock, because the stock price moves down approximately the same value as the dividend paid to the shareholder. This is not true in options. An option does not give the holder the right to receive a dividend. Thus, when a dividend is paid and the stock subsequently falls, an option holder bears the full brunt of the dividend paid. While this is a negative characteristic for a holder of a call option, the holder of a put option, who is betting the stock will go down anyway, actually gains from this occurrence. Of course, the options market anticipates the impact of upcoming dividends and tends to discount for this effect just before the dividend is paid. Remember, an option does not give the holder ownership rights, voting rights, or a share of the company; it entitles the owner to benefit only from the stock's price movement.

Defining Stock Options

Stock options are investment instruments known as derivative securities, which means that each stock option derives its value from an actual stock or equity. In other words, a stock option's value is directly dependent on the price movement of its underlying security. For example, the value of Coca-Cola options are derived from 100 shares of Coca-Cola stock. Each option will have an underlying security.

Having established that stock options all have an underlying security, the next point to understand is that a stock option is a contract which represents the right to buy or sell shares of the underlying stock. Each contract generally represents 100 shares of the underlying stock, and there are no partial contracts. Options traders can own as few as one contract and as many contracts as their options trading capital will allow.

Buying a stock option contract does not obligate you to purchase or sell actual shares of the underlying stock. It only signifies that you have the right, or option, to buy or sell.

What is a call option?

A call option is a contract giving its holder the right to purchase shares of the underlying stock. Purchasing a single Nike call option gives an option trader the right, but not the obligation, to buy 100 shares of Nike stock at a predetermined price during a specified period of time.

Put Options

A put option is a contract giving its holder the right to sell shares of the underlying stock. It is not necessary for a stock options trader to own shares of a particular stock in order to buy a put option. If an options trader purchases a single General Motors put, he or she has the right, but once again not the obligation, to sell 100 shares of General Motors stock for a particular window of time and at a certain price.

Types of stock options

The two types of stock options, calls and puts, determine whether the option holder's right is to buy or to sell the underlying shares at a designated price and within a designated period of time.