|Stocks & Mutual Fund Information|
What the Hell is a Stock option?
A 'stock option' is a contract between two parties giving the buyer (also known as the 'taker') the right, but not the obligation, to either buy or sell a specific quantity of shares at a pre-agreed price (known as the 'strike price' or 'exercise price') by a certain future 'expiry' date. There are two different types of options that can be traded, known as 'call options' and 'put options'.
For an option contract to be traded there must be both a 'buyer' and a 'seller' involved in the transaction. The buyer pays an upfront amount; known as the 'premium', to the option seller (the seller is also often referred to as the 'writer' of the option contract). In the Australian market, each option contract typically covers 1,000 of the underlying shares and the premium is expressed as a specific number of cents per share.
Buying Call Options:
A Buyer of Calls aims to profit by a rising stock price, as they have locked in a "purchase" price at which they can buy the underlying shares at whenever they wish up until the expiry date.
Selling Call Options:
Buying Put Options:
Selling Put Options:
OK now for some examples to show you a few basic ways of buying and selling put and call options:
So let's say you've found a share that you think will increase in price and think you can make a profit if you are right. Rather than buy the actual shares, you might decide to purchase some Call Options. This will enable you to spend much less capital but can still get the benefit from the rise in the share price.
Maybe you own 1,000 shares in a company and the share price appears to be flat and going nowhere, so you decide to sell a Call Option against those shares. This will earn you a premium income. This way, even if the shares are right where they started when the Expiry Date comes along, you've made a small amount of money.
Your share has gone though a recent rise and the share price seems to have flattened out and you are now concerned that your share price might fall. You decide to purchase some Put Options, knowing that if the shares do fall, you've locked in a selling price and now have a form of "insurance" on your shares to protect you from losing too much.
There's a share you'd be happy to own, but only if it was at a lower in price, so you decide to sell some Put Options at a Strike Price just below the current market price and you'll receive a premium upfront. When the Expiry Date comes along, if the share is above the Strike Price you won't have to buy the stock and will be able to retain the premium. If the share is under your Strike Price, you'll be Exercised and hence forced to buy the shares at the pre-agreed price.
Here a list of some important terms which you will find are regularly used when referring to options:
All Ordinaries Index:
At-Market or At-the-Market:
At-the-Money (ATM): An option whose strike price is equal to (or close to) the current price of the underlying stock.
Australian Stock Exchange (ASX): Six Australian trading floors are linked through the Stock Exchange Automated Trading Systems (SEATS). Administrative headquarters are in Sydney.
Avoidable Risk: Risk items that can be eliminated through management. Bearish Someone is said to be a bear or be bearish if they think a stock or the market is going to trend down over a particular time frame. Also a negative or pessimistic outlook.
Bear Market: A declining stock market, usually over a prolonged period. Also, a market in which prices of a certain group of stocks are falling or are expected to fall.
Bear (or Bearish) Spread:
Bear Call Spread:
Bear Put Spread:
Blue Chip Stock:
Bull (or Bullish) Spread:
Bull Call Spread:
Bull Put Spread:
Covered Cash-Secured Put:
Exchange Traded Options (ETOs):
Liquidity / Liquid Market:
Premium: Price a buyer pays to an option writer for granting an option contract.
Rolling: A trading action in which the trader simultaneously closes an open option position and creates a new option position at a different strike price, different expiration, or both. Variations of this include rolling up, rolling down, rolling out and diagonal rolling.
This is just an introduction to world of exchanged traded options and I hope this may have sparked an interest inside you to explore the world further.
Author Raymond Heye has been trading options and found all kinds of secrets that he is willing to share with others though several articles he has written To learn more, visit: http://www.ourmoneyfarm.com
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