A stock option is a form of derivatives contract in which the buyer of an option pays a premium for exercising the right to buy or sell the underlying stock. The holder of the stock options has the right to buy or sell but is not obliged to do so. This level of flexibility is a distinct advantage that comes with a price, namely a premium. It is up to the buyer to exercise his/her option. In case the buyer chooses to exercise an option, the seller is obliged to buy or sell the underlying stock.
How does Stock Option Trading Work?
Stock option trading is carried out in a stock exchange. The exchange is responsible for laying out specifications of the trade. Specifications include number of shares to be bought or sold, the amount at which to buy or sell and the future date before which the option is to be exercised. The seller of the option is obliged to buy or sell when the buyer of the contract wishes to exercise the option, regardless of the market price of the stock fluctuations.
A call option gives the buyer a right to buy the stocks whereas a put option offers the right to sell. The price of buying or selling is typically termed as the exercise price or the strike price. A company’s stock tends to trade at a given exchange based on this strike price.
Benefits of Stock Option
· Stock options provide an investor with a higher leverage to control more assets with less money. For instance, one option can control 100 shares if it is traded in the US.
· Since options are vulnerable to movements in stocks and the costs of buying an option is low, it offers a high percentage of returns.
· It cushions the holder from unfavorable price movements and allows the holder to take advantage when price movements become favorable.
Risks of Stock Option
Risks include any changes that occur in the highly volatile climate may affect the options market in an adverse way. Another risk pertains to insolvency of the brokerage firms
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