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Before You Trade: Your Essential Investing Guide

Views 3683Apr 1, 2024
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Getting Started with Basics

In this chapter, we'll walk you through some of the basics about stock options.

A stock option is a contract between a buyer and a seller.

The buyer pays a certain amount of money to the seller. In return, he or she gets the right to buy or sell securities at an agreed price on or before a specified date.

The seller receives a certain amount of money from the buyer. The seller then has an obligation to buy or sell securities at an agreed price on or before a specified date.

There are two types of options: calls and puts.

A call option gives its holder the right, but not the obligation, to buy shares of the underlying stock at the strike price on or before its expiration date. Conversely, a put gives its holder the right, but not the obligation, to sell shares of the stock at the strike price on or before its expiration date.

There are four key elements in an option contract: the underlying stock, the strike price, the premium, and the expiration date.

The underlying stock refers to stock that must be delivered or received when exercising an option contract.

The strike price is the price per share at which the underlying stock can be purchased or sold by the option trader when exercising an option.

The premium is the current market price of an option contract. It is determined by several factors, including the time left until the contract expires and expectations for future volatility of the underlying stock price.

The expiration date is the date on which an option expires.

If the buyer of an option doesn’t exercise the contract prior to expiration, he or she will lose the premium paid for the contract.

Traders can find these option elements in a table called the "option chain." Option chains on different trading platforms may look different, but their layouts are similar.

Let's look at the option chain of a theoretical company, Rabbit, Inc. (Stock symbol TUTU).

The table shows a list of available option contracts for Rabbit company.

Suppose a trader buys a Rabbit March 18th $36 call option. “Rabbit” is the underlying stock, $36 is the strike price, and March 18th is the expiration date. There are 30 days left till the contract expiration. This contract gives the trader the right to buy shares of Rabbit stock at $36 on or before March 18th.

The premium for the contract is $4.00 per share. In this example, let's assume each option represents 100 shares of the stock, so it costs $400 (4*100) to buy this call option.

If a trader buys a Rabbit March 18th $40 put option. “Rabbit” is the underlying stock, $40 is the strike price, and March 18th is the expiration date. This contract can give the trader the right to sell shares of Rabbit stock at $40 on or before March 18th.

The premium for the contract is $3.9 per share. It costs $390 to buy this put option.

As there's a difference between the stock price and the strike price, an option can fall into three groups: in-the-money, at-the-money, and out-of-the-money.

For calls, an option is in-the-money if the stock price is above the strike price. It is at-the-money if the stock price is equal to the strike price. It is out-of-the-money if the stock price is below the strike price.

For puts, an option is in-the-money if the stock price is below the strike price. It is at-the-money if the stock price equals the strike price. It is out-of-the-money if the stock price is above the strike price.

It's worth noting that many factors can affect the premium. We'll discuss them in the next chapter.

Disclaimer: This content is for informational and educational purposes only and does not constitute a recommendation or endorsement of any specific investment or investment strategy. Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. It is important that investors read  Characteristics and Risks of Standardized Options before engaging in any options trading strategies.

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