Options Investing 101 – Part 1



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Nov 05 2006
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While option trading is being seen and treated as something which is rare like Dinosaur in Malaysia (Singapore has been mooting this option trading for quite sometime but have still to set a concrete plan to introduce it), it was started in United States since April 26, 1973 with the establishment of Chicago Board Options Exchange (CBOE). For more information on history of option trading, stocktube previous blog titled History Of Options Trading – Part 1 and History Of Options Trading – Part 2.

What is an option?

A stock option is a contract which gives the buyer the right, but not the obligation, to buy or sell shares of the underlying security or index at a specific price for a specified time. Stock option contracts generally are for 100 shares of the underlying stock. There are two types of options, calls and puts.

What is a call option?

A call option gives the buyer the right, but not the obligation, to buy the underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy.

What is a put option?

A put option gives the buyer the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell.


What is the option premium?

The premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option. In return, the writer of the call option is obligated to deliver the underlying security to an option buyer if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.

What is a strike price and how is it determined?

The strike, or exercise, price of an option is the specified share price at which the shares of stock can be bought or sold by the buyer if he exercises the right to buy (in the case of a call) or sell (in the case of a put) and is the actual numeric value of the option upon exercise . For example, a May option may have strike prices of 45, 50 and 55. Strike prices are determined when the underlying reaches a certain numeric value and trades consistently at or above that value. If, for example, XYZ stock was trading at 49, hit a price of 50 and traded consistently at this level, the next highest strike may be added.

What is an at-the-money option? An in-the-money option? An out-of-the money option?

When the price of the underlying security is equal to the strike price, an option is at-the-money. A call option is in-the-money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security. A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the money if the strike price is less than the market price of the underlying security.

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