Trading equity options can be confusing to anyone who is unfamiliar with the terminology involved. By mastering a basic understanding of the vocabulary, an investor can then begin to understand how these derivatives may be used to enhance the performance or hedge against the decline of an equity portfolio.
An option is a contract between two parties that specifies a group of conditions by which the purchaser of the contract may exercise the rights of that contract, and the seller is obligated to perform under the conditions of that contract. The typical equity option contract covers 100 shares of common stock.
The strike price is that price at which it is agreed in the contract that the common shares will change hands. An option with a strike price of 40 means that the stock will be exchanged at $40 per share.
The expiration date of the option contract for American style options is the third Saturday of each month. Since options do not trade on Saturday, the last effective date for trading an option contract is the third Friday of any particular month.
Option contracts do not exist until someone writes a contract. Therefore, the writer of an option contract can be thought of as the original seller of a contract, although a particular contract can be bought and sold many times by various parties.
A call option gives the holder of the option the right to purchase the stock at the strike price regardless of the current market price of the stock at any time before the expiration date of the contract for American style options.
A put option gives the holder of the option contract the right to sell the stock at the strike price regardless of the underlying price in the open market at any time prior to option expiration.
When the holder of an option contract, whether a call or a put, wishes to enforce the terms of the contract, he is said to exercise the option.
Learning a new skill often involves understanding the terminology being used by its practitioners. This vocabulary becomes the foundation for more advanced skills and ideas within that field. Starting with these basic option definitions will allow an investor to learn more about trading this type of derivative.
Exploring financial derivatives can be a tricky prospect. The term "derivatives" encompasses many different types of financial instruments, so truly understanding derivatives requires you to understand all these underlying instruments. The two main types of derivatives that the average investor is likely to encounter are options and futures.
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