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  4. Understanding Options (option on a stock)

    An option on a stock is a contract conferring on the buyer the entitlement to sell or buy an underlying asset at a certain price on or before a particular date. An option is a security like a bond or stock. However, it also has other stated terms and features.

    When you purchase an option, you have a right but not a obligation to execute the terms of the option. You can allow the date of expiration to go by. Then the option loses its value. You will then forfeit the money you paid for the option.

    Since an option is a contract that is based on an underlying asset, it is called a derivative. This indicates that it gets its value from another security. An underlying asset in the stock market is either an index or a stock.

    There are two kinds of options; calls and puts.

    1. Call

    The holder of a call is entitled to purchase an asset at a predetermined price within a specified period. A call has a resemblance with a long position on a stock. Holders of calls believe that the price of a stock will appreciate significantly before the option lapses.

    2. Put

    The holder of a put is entitled to sell an asset at a predetermined price within a specified period. A put is similar to holding a short position on a stock. Holders of puts believe that the stock price will drop before the expiration of the option.

    Key Players in the Option Market

    Four kinds of players in options market are sellers of calls, buyers of calls, sellers of puts, and buyers of puts.

    People who sell options are called writers and those that buy options are called holders. The sellers are considered to have short positions while the buyers have long positions.

    Distinctions between Sellers and Buyers

    1. It is not compulsory for the buyers (holders of puts and holders of calls) to sell or buy the underlying stock. They can use their rights if they wish.

    2. It is obligatory for the sellers (writers of puts and writers of calls) to sell or buy. In other words, a seller has to keep to a promise to buy or sell.

    Terminology of the Options Market

    To trade in the options market, you should know some technical terms that are used.

    The strike price is the price that an underlying stock can be bought or sold. The price of a stock must be greater (for calls) or lower (for puts) than the strike price before you can exercise a position for a profit. Moreover, this must take place before the expiration date.

    For call options, an option is in-the-money if the stock price is greater than the strike price. A put option is in-the-money when the stock price is lower than the strike price. The intrinsic value is the amount by which an option is in-the-money. Premium is the total cost or price of an option.