A stock option is an accord between two parties to buy or sell the underlying stock at a predetermined price and specific time period. Traders invest in stocks to maximise their profits using derivative products. Investors of the stock options have to study the market and polish their skills to trade in such market options. The seller of the stock option is referred to as the option writer.
The seller’s of options get a premium for the contract that the investor purchases. Traders, however, have to determine in advance the factors that impact the stock options. To study the factors, traders have to study the stock options and their trading for accurate decisions and high profits.
In the article, all the aspects of stock options are discussed to analyse the terminology and its factors.
What are Stock Options?
Stock options are the derivative products that provide the traders with the right to buy or sell the stocks without any obligation to do so. Instead, the price and time period of the underlying stock is predetermined by the trade parties. Stock options are of two types, primarily call and put options.
Traders can invest in the stock options; generally, one contract of the stock options represents a hundred shares of the underlying stock. The put options bet on the fall of the price, whereas call bets on the rise in the price of the stocks. So, traders can bet on the stock options using the call and put options depending on the share market value.
These are the financial instruments that derive their value from the market worth of the underlying stocks. In the trade of stock options, the market worth of the shares of the company traded decides its value in the market.
The contract of stock options is based on a certain date and time specified by the trade parties, which is based on a few months from the date of the trade. The traders on the date of agreement based on the future get a price for the contract called the strike price.
The value of options is set on the difference between the underlying stock price and the strike price of the stocks.
The two categories of stock options, the call and put options, are used greatly by traders to speculate. In call options, investors are allowed to buy the stock at a certain price and time. Whereas the put option is the opposite of the call option, where the investor sells the stock at a certain price and time.
Styles of Stock Options
The stock options are traded in two styles based on the requirement of the investors and traders. These styles allow them to buy or sell and exercise their right on the stocks. The two different styles of trading stock options are:
- American style
- European style
The American style of trading gives traders and investors of the stock options the right to exercise the stocks between the purchase and the expiration date. In contrast, the European style can be exercised only at the time of expiration, which makes it less common among traders.
The factors of the styles that traders should be aware of are discussed below:
Expiration Date
A unique feature of derivative trading is it offers the traders the option to decide on the expiration date and the style they would like to use with the expected rise and fall in the price. Thus, traders can bet on the stock’s rise and fall with specific dates as per the traders choice. The specific date of the stock option agreement is termed the expiration date.
It is significant for the traders to price the value of the call and put options called the time value. The terminology is used in various option pricing models to determine the value of the stocks.
Contracts
The contract is a sign of the options that traders can look for to buy in the market. Traders can buy the shares and sign contracts with the party to earn good profits.
For example, a trader invests in stock options buying one call contract, so the trader owns $100 calls. So, imagine if the stocks rise above $100 by the expiration date, the trader then has the option to buy the shares of the company, let’s say, 500 shares at $100 without considering the current market worth of the stock.
But, if the opposite happens and the value of the stock goes below $100, then the options purchased will be worthless. Traders will lose the funds spent to purchase the options called the premium.
Strike Price
The strike price is the value traders expect of the stock option, below or above the current price by the expiration date. Thus, the price helps traders to determine whether they should exercise the option or not. For instance, a trader wants to buy a stock option of the company, which he believes will increase in the coming month to buy the stocks with the specific date and price. Thus, earning from the investment with a good market study.
Premium
Premium is the amount paid by the trader to buy the stock option. Traders determine the premium by taking the call price and multiplying it with the number of contracts bought and at last multiplying the value by 100. Similarly, when traders believe that the price will fall, they will go for put options with the same procedure.
Trading Options
Traders have options in the stock options market to buy or sell the underlying stock. Moreover, they can speculate on the stock options and hedges to have traded as per their requirements. It all depends on the strategy traders want to use.
Traders can buy the stock options using call or sell with the put option. It is all up to the trader and their market analysis and strategy to help them trade the stock options.
Factors that determine Stock Option
Stock options trading is not that easy; traders can not blindly determine the pricing or value of the stocks without getting into the details of the factors affecting them. Traders should be aware of the factors that impact the trading of the underlying stocks and their pricing. Mentioned below are the seven factors that influence the pricing of the stock options.
Current Stock Price:
The current stock price affects the stock options, as when they trade at a price, traders have to pay more for the purchase. For example, traders buy the stock of XYZ company at $400 per share, so for buying it at call option, traders will pay more logically. The call option is closer to the time money. Similarly, when a trader buys the put option, he would do the opposite.
Strike Price:
The strike price is the value at which the call option trader purchases the stock option and the put option trader sells. It plays an important role for traders. When the strike price moves low, it becomes expensive for call option traders, and the put options become expensive when the strike price increases.
Type of Options:
The third factor that has an impact on the stock option pricing is the type of option a trader chooses. It may be a call or put option; this entirely depends on the traders and which side of the market they want to invest in. Traders can easily understand the call and put option trading as they have not much confusion.
Expiration date:
The trading of stock options comes with an expiration date which has two styles of trading. Traders can use the American and the European option style to trade. In the first style, traders can exercise their rights any time from purchase to expiration date.
Whereas in the second style, traders can only exercise their right at the time of expiration. So, traders can use the one that suits their investment.
Interest Rates:
Interest rates are a small factor of the stock options trading but still have some impact to analyse it in trade. When the interest rate of the stocks rises, then the call options value also increases. So in the call option that traders invest instead of stocks, they enjoy interest due to the extra cash. However, this is hardly significant in the real world, but it is stated in theories.
Dividends:
Dividends are paid on the stocks held by the traders, and when the trader does not pay dividends on the stocks, it is called the ex-dividend. This is because the value of the stock goes down by the dividend amount.
When the dividend increases of the stock, the puts are more worthy than the call option. Thus, it makes the value of the call option low.
Volatility:
Volatility is the uncertainty of the market, which brings changes in the market dynamics. It measures the day to day change in the price of the stock in the market. Traders have to be careful of this factor as this may earn profit and lead to loss.
How do Stock Options work?
The stock options are derivatives that are more feasible to invest in as traders have no obligation. They can simply buy or sell the underlying stock option and trade in the market. The most used trading strategies of stock options trading are speculation and hedging. Mostly, these are used for attracting employees of the firm and for retaining the current employees.
Traders get these at discounted rates and can trade them in the open market. The company providing the stock option uses the technique called vesting. In vesting, the employers encourage their employees to stay in the vesting period to grant the shares. The stock option of the company can only be exercised when the vesting period requirements are met.
Once done with this, traders have to; next, there are time limits for exercising the stock options, which traders should be familiar too.
Traders can exercise their rights by using the following options:
Cash Payment: Traders can use cash payment options to acquire the stocks. The cash payment covers up all the costs of the stock option.
Cashless: The employees are allowed to exercise their options using the cashless option. In this option, the employer sells the stock options to the employees to cover the cost invested for acquiring the stocks.
Selling shares exercised at current market price: Traders can use this when they do not have market exposure to market volatility. In this, traders do not have to come up with cash for the transaction costs while exercising the right. However, it has tax charges which are not favourable.
Reason to buy Stock Options
The article has discussed every aspect of stock options trading, where the traders can bet on the increase and decrease of the prices of the stocks at a specific time and date. Traders of the market use the stock options as a hedging technique to earn profits. Thus, minimising their market risks. Moreover, the stock options allow traders to speculate on the price of the stock traded in the market.
So, the overall reason to invest in stock options is the minimising of trade risk and the opportunity to earn without having ownership with market exposure.
Conclusion
Trading in the stock option is a profitable derivative product that would help traders avoid risks and maximise profits. Stock options have an expiration date, premium, trading options, contracts and strike price, which makes the risks predictable and trade enhanced. A trader should definitely go for investing in stock options.
Stock options could be traded via stockbrokers or online market brokers such as Brokereo. These brokers serve the trader with effective trading tools and services that would make the trade more feasible with the execution of orders and strategies being made easily. Read our Brokereo Review for a better understanding of the broker.
A trader should invest in stock options, but they have to consider the factors of the market for beneficial trade. The strike price, expiration date, current stock price, dividends, interest rates, volatility and trade options are essential for a successful stock option trade.
