Understanding The Basics Of Stock Options
Although stock options aren't essential for most investors, taking time to understand how these complex investment vehicles work can open new vistas and create entirely new opportunities. In general, stock options are simply a type of financial derivative that let investors purchase or sell a certain stock at a specified price within a specified period. Options are often traded on stock exchanges as shares on the market; however, they can also be traded independently. The cost of an option depends on the value of the underlying stock, the strike price, the premium paid, and whether a buyer or seller has the right to sue for compensation should the stock price drop. An option is usually not exercised until the date on which it was originally stated. Read more
As an example, a call option is purchased by an investor to allow him to purchase a stock at a specified strike price in the future. If he decides to exercise his option, the buyer will pay the seller a fee known as the strike price fee. The strike price refers to the current price of the stock. However, since the buyer never exercises his right to purchase the security, it never receives an exercise price and therefore never becomes a valid contract.
Financial derivatives are designed to provide the investor with a method to offset risk in their portfolio by reducing or eliminating the risk inherent in certain transactions. These types of derivatives are generally traded between two parties, generally two hedge companies. A hedger agrees to hedge a particular contract in return for a fee. The contract could be to sell the security or to buy it at an agreed-upon price. An option gives the investor the right to sell or buy a certain stock at a fixed date, known as a strike price.
Stock options come in two forms: call and put. A call option gives the buyer the right to purchase a stock at a pre-determined price within a set period (the expiration date). A put option gives the buyer the right to sell a stock at a pre-determined price within a set period (the expiration date). Both options are usually used to offset risk in the underlying portfolio. Since the underlying asset is not controlled by the investor, this type of contract is not considered a direct investment.
However, many people use stock options for speculation. Speculation refers to the process of predicting an interest rate, index, currency, etc. This process also applies to the underlying asset. As an example, speculators may predict oil prices in the future; they also make use of derivatives to do so.
For long-term investors who want to make a profit from their portfolios, it is very important that they understand the risks associated with derivatives and how to reduce this risk. Good financial professionals like Certified public accountants (CPA) and Certified money managers (CMM) can provide sound advice on when and what to trade. Moreover, stock market investors should learn about derivative instruments like put and call options, when they should buy or sell them, and how to price them correctly. With proper knowledge of these instruments, investors can increase their profit margins significantly.