Stock options explained: An Easier Approach

Recently, many new investors want stock options explained. If you are new in the field, it is hard to grasp the idea of it. For definition, stock option is a right to buy some stocks at a certain price at a certain time in the future. But definition does not explain much and most of the time this hard and dry definition helps very little to understand what stock options really are.

For those who want the stock options explained in more detail, it is an agreement between the owner of the stock and the buyer of the option for a future transfer of the ownership of the stock at a fixed price regardless of the real price of the stock at time of the transfer. This is buying only an agreement of the selling or purchasing of the stock and not the stock itself. There are two types of stock options, one is a call, and another is a put. Call is the right of buying the stock and put is the right of selling the stock. All stock options have an expiration time after which the right of selling or buying cannot be exercised. So, an option is the right to buy or sell the stock at a predefined price which can be exercised in a predefined time. And, buying an option is buying this right.

An example can get stock options explained more clearly. Let’s imagine a company called company. The current stock price, say June 2011 of the company is $70. If we first talk about call options, let’s say some person named person buys the stock option of buying the stock at $80, the price of the option itself being $10 and an expiration date of September 2011. So, if the stock price increases up to $100 at August 2011, the person can buy the stock at $80. His total cost would be $80+$10=$90, gaining $10. But if the stock price falls to $50 he can buy it at $80 losing $40 ($30 for stock price decrease and $10 for the options price). But in this case, he is not obliged to buy the option and can let it expire. In case of expiration, the only loss of the person would be the price of the option, which is $10.

Also, for put option, say the company buys the option to sell the stock at $80. If the price of the stock falls to $50, it can sell the stocks at $80. If the price of the option is $10, then the company gains 20$. If the price increases to $100, the company can either exercise the option and lose $20+$10=30$ or can let it expire, losing only the price of the option.

From the stock options explained in the above example, we can see that buying a call option is a good choice only when the price of the stock is likely to rise, where buying a put option is good when the price is likely to fall.

However, understanding the stock options from this may be helpful, but it is a good practice to consult licensed firms for advice and research a more for the stock options explained more clearly before investing any money on it.

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