What are stock options?
A stock option is an agreement which gives you the right (but not the obligation) to buy or sell underlying stock at a fixed price (the strike price) on or before a given future date (the expiry date). Each option is typically over 100 shares.
The two parties in an options contract are the seller (also termed “writer”) and the buyer (also termed “taker”). Similar to an insurance policy, the seller of an option receives money – the premium – to take on the risk that the price of the underlying share finishes above or below a certain price on a specified future date. The buyer pays the premium to be assured of a fixed price for a transaction in that share on that future date.
The buying and selling of options is happening on organised options exchanges, therefore the name “Exchange Traded Options” or “ETO”. The underlying asset of an option could be futures, stocks, commodities or other derivative instruments.
The two types of options
There are two types of options: call options and put options. In short the difference can be described like this: the buyer of a call option has the right to buy stock at a fixed price, while the buyer of a put option has the right to sell the underlying stock at a fixed price. For more exact descriptions please read our What is a call option and What is a put option pages.
Why trade stock options
The value of an option will grow or shrink along with the value of the underlying asset. Instead of exercising an option – which means to buy or sell the underlying shares – the options themselves can be bought and sold. You can trade them to make a profit (or loss!). Trading stock options offers great advantages over the trading of shares:
- Options offer great leverage. For a relatively small premium the holder of an option can have exposure to a large quantity of underlying shares.
- Options allow one to strictly limit the maximum possible loss on every trade.
- Options offer immense flexibility and can be combined into options trading strategies to exploit every conceivable market condition.
Further information in our Free Options Trading eBook
Note: If the above information left you with questions or you would like to learn more about related topics, please make sure you download our Free Options Trading eBook which we compiled with a wealth of information about options trading for all levels of traders, including recordings, examples, charts and lots more!
To give you an idea, these are the topics covered in our eBook:
For the beginner:
- What is an option?
- The intrinsic value of an option
- Time decay
- The myths of options trading
For the intermediate trader:
- Options terminology
- Why we use spreads
- Bull call spread example
- Bull put spread example
- Where to learn how to trade volatility and price
For the advanced trader:
- The psychology of trading
- Developing your trading system
- Trade example