stock option

What It Is

A stock option gives the holder the right, but not the obligation, to purchase (or sell) 100 shares of a particular underlying stock at a specified strike price on or before the option's expiration date. There are two kinds of options: American and European. American options differ from European options in that European options allow the holder to exercise only on the expiration date.

How It Works

All options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. For example, let's say you purchase a call option on shares of Intel ({ia_ext|Nasdaq: INTC|http://www.streetauthority.com/stocks/INTC}) with a strike price of $40 and an expiration date of April 16. This option gives you the right to purchase 100 shares of Intel at a price of $40 on or before April 16th (the right to do this, of course, will only be valuable if Intel is trading above $40 per share at that point in time).

Every option represents a contract between a buyer and seller. The seller (writer) has the obligation to either buy or sell stock (depending on what type of option he or she sold--either a call option or a put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an options contract has the right, but not the obligation, to complete the transaction on or before a specified date. When an option expires, if it is not in the buyer's best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future -- hence the name.

As a quick example of how call options make money, let's say IBM ({ia_ext|NYSE: IBM|http://www.streetauthority.com/stocks/IBM}) stock is currently trading at $100 per share. Now let's say an investor purchases one call option contract on IBM at a price of $2 per contract. Note: Because each options contract represents an interest in 100 underlying shares of stock, the actual cost of this option will be $200 (100 shares x $2 = $200). This American contract happens to say the investor can purchase up to 100 shares for $100 each on or before January 1.

Here's what will happen to the value of this call option under different scenarios:

When the option expires, IBM is trading at $105.
Remember: The American call option gives the buyer the right to purchase shares of IBM at $100 per share on or before January 1 (rather than only on January 1, as would be the case with a European option). The buyer could use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. This option is therefore called “in the money.” Because of this, the option will sell for $5 (because each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500). Because the investor purchased this option for $200, the net profit to the buyer from this trade will be $300.

When the option expires, IBM is trading at $101.
Using the same analysis, the call option is worth $1 (or $100 total). Because the investor spent $200 to purchase the option, he or she will show a net loss of $1 (or $100 total). This option is called “at the money,” because the transaction is essentially a wash.

When the option expires, IBM is trading at or below $100.
If IBM ends up at or below $100 on the option's expiration date, then the contract will expire “out of the money.” It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the full $200 that he or she spent for the option).

The Black Scholes model is a formula used to assign prices to option contracts, but it is geared toward European options. American options command higher prices than European options because the American options essentially allow the investor several chances to capture profits, whereas the European options allow the investor only one chance to capture profits.

Why It Matters

Investors use options for two primary reasons -- to speculate and to hedge risk. To speculate is to simply bet on the direction of price changes. Hedging, however, is like buying insurance -- it is protection against unforeseen events. Using options to hedge your portfolio accomplishes this for some investors.

In general, European options are riskier than American options because they allow only one day of exercise opportunity to the investor. American options give the underlying stock more chances on which to rise enough to put the option in the money. For sellers of European option contracts, this all can be an advantage.

Many index options are European options, so investors should be sure to understand the nature of what they’re buying.

Source: Investing Answers