An option is a contract the gives the holder a right, but not an obligation, to carry out a certain transaction. When it comes to stock options, the most commonly found stock option is the one where the holder has the right to buy a certain stock for a fixed price. The fixed price is called the strike price or the exercise price.
The stock option is just one of many option types. Examples traded financial options are currency cross rate options, commodity options, equity options, callable bull/bear contract options, futures contracts options, and interest rate options (including bond options). The warrant is a financial instrument that is quite similar to a call stock option.
When can I exercise my stock option?
That depends on the type of stock option. With a European-style call stock option, you can buy the underlying stock on the day of expiration. With an American-style call stock option, you can buy the underlying stock at any day until the option expires.
What is the difference between a call option and a put option?
A call option gives the holder the right to buy the underlying asset (e.g. stock). A put option on the other hand gives the holder the right to sell the underlying asset.
Buying a stock option
Stock options are traded on exchanges and over-the-counter (OTC). The price you pay when purchasing a stock option is called premium.
Before purchasing a stock option, one should always take a look at the term sheet to find out the terms of the stock option. The term sheet will include a lot of important information.
- The identity of the writer. The writer is the entity that created the stock option and it is the writer that is obliged to honor the stock option and ensure that you can exercise your right if you want to.
- The settlement terms. These terms will show you if the writer is obliged to actually buy/sell stock, or if the writer can simply pay cash to the option holder instead.
- Details about the underlying stock. A company can issue various types of stock, e.g. A stock and B stock.
- A stock option can give you the right to purchase more than one share, e.g. 50 shares or 250 shares. This will of course impact the market price of the stock option. The strike price will be expressed as the price per share.
- Is this a European-style stock option or an American-style stock option or something more exotic? When is the expiration date?
Trading stock options on an exchange
The stock options traded on exchanges are typically highly standardized contracts, with a specific ticker symbol. The exchange will not just set rules for the options trade; it will enforce these rules as well.
Trading stock options on an exchange adds an extra layer of security when the option contract is backed by the credit of the exchange. If the writer is unable or unwilling to honor the stock option, the exchange will step in and honor it. Exchange traded standardized stock options are normally settled through a clearinghouse, so the writer and the holder never have to be in touch with each other or even know the identity of each other.
Trading stock options over-the-counter (OTC)
Trading stock options over-the-counter (OTC) means forgoing the security, regulation and standardization ensured by an exchange. An OTC trade is simply a trade between two individual parties. Since the options contracts aren’t subjected to standardization, it becomes extra important to check every detail of the term sheet, and also investigate the reliability of the writer.
The possibility of trading non-standardized stock options is one of the appeals of OTC trading. An entity can write or purchase a tailor-made stock options contract. An options contract created for a specific business requirement is generally referred to as a dealer option.
Binary Options based on stock
Binary options are not really options at all. They are financial instrument used to speculate on the movements of underlying financial instruments. These instruments can be stocks but also currency pairs, commodities or indices. Binary options can not be traded once they have been purchased. Binary options are only available through special brokers such as IG Index, Banc de binary and StockPair. StockPair is a good choice for anyone who are looking for binary options based on stocks. If you want to know more i recommend that you read this StockPair review.
Stock options that aren’t traded
Employee stock options that can only be exercised by the original holder (the employee) naturally have no secondary market.