Introduction To Options Trading, Part 2

Summary: An option is a contract that provides you with the right to execute a stock transaction-that is, to buy or sell 100 shares of stock. (Each option always refers to a 100-share unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future. When you have an open option position, you do not have any equity in the stock, and neither do you have any debt position. You have only a contractual right to buy or ...

An option is a contract that provides you with the right to execute a stock transaction-that is, to buy or sell 100 shares of stock. (Each option always refers to a 100-share unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future. When you have an open option position, you do not have any equity in the stock, and neither do you have any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the fixed price. Since you can always buy or sell 100 shares at the current market price, you might ask: "Why do I need to purchase an option to gain that right?" The answer is that the option fixes the price of stock, and this is the key to an option's value. Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable, which makes stock market investing interesting and also defines the risk to the market itself. As an option owner, the stock price you can apply to buy or sell 100 shares is frozen for as long as the option remains in effect. So no matter how much price movement takes place, your price is fixed should you decide to purchase or sell 100 shares of that stock. Ultimately, an option's value is going to be determined by a comparison between the fixed price and the stock's current market price. A few important restrictions come with options: