Stock Option: Important Components

Stock Option Trades have several key components that are both vital to understand before you even begin to think about trading stock options.  Several factors determine the particular way in which each stock option will lead to a successful or losing trade.

These factors are…

1)      The Strike Price is the price at which the security (stock, ETF, etc.) upon which the option is based will be exchanged if the option is exercised.  Your broker provides information on many different common price levels at which you can agree to participate.

2)      The Expiration Date is that date at which this exchange will happen if it is going to occur.  This happens if the option is “in the money” which means that the security price for a call option is above the strike price of the option or that the security prices of the put option is below the strike price of the stock option.  There are periodic established expiration dates from which you can choose.

3)      The Option Price is the price at which both the buyer and the seller agree to the trade.  Only you can decide whether or not to enter the trade and thus you determine your price.  However, you can only enter the market if there is a willing counterparty.  The market where this price is determined is influenced by several dynamics of the market.  Some of these are:

  1. The Difference between Strike Price and Current Market Price – An option which is already in the money is going to be far more expensive than an option that is very far out of the money.  This is because the option which is already in the money is pretty likely to be exercised while the option that is far out of the money is less likely to be exercised.
  2. The Time Till Expiration – Generally, the longer the span of time between now and the expiration of the option, the higher the price will be.  This is again because the option is more likely to be exercised if the there is more time for the market to move in the option’s favorable direction.  So if you own an option the value will continually drop as time goes by assuming nothing else changes.
  3. The Volatility in the Market – If the market is gyrating explosively and especially if it is falling, there will be more fear in the market and option prices will be higher.  People are more willing to pay the cost of insurance of options as a hedge.

In some ways these things are theoretical because the price of your stock option is simply the price at which the buyer and seller agree.  However, these factors definitely affect the market price at which you’ll be able to enter an option trade.

An Option represents the right to buy or sell 100 shares of a stock (or some other security).  Always remember that when you are reading the price for an option, you will actually pay (or get paid) 100 times this amount for the option and you are buying or selling.  Likewise, you are either buying the right to, or committing yourself to the obligation to trade 100 shares.

This is Pt 2 of a new series which we’ll be revisiting every few days.  You can find Pt 1 here. You can check out the series we just finished on professional money management and funds by following these links: Pt 1, Pt 2., Pt 3, Pt 4, Pt 5, & Pt 6.

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