How to Explain Option Trading
Reduce Risk and Profit!
by Ian Harvey
To explain option trading, the first thing that must be made clear is what a stock option is.
According to LAW.com Dictionary, a stock option is “the right to purchase stock in the future at a price set at the time the option is granted (by sale or as compensation by the corporation). To actually obtain the shares of stock, the owner of the option must ‘exercise’ the option by paying the agreed upon price and requesting issuance of the shares.”
In other words, a stock option is a legal contract giving the owner the right to buy or sell a quantity of stock at a set price on or before a specific date.
A ‘legal contract’ in the context of options trading, means that the stock option is regulated by the SEC (Securities and Exchange Commission), managed by the Option Clearing Corporation, and is standardized.
Since this structure is imposed, a stock option is traded on an exchange similar to stock. This allows liquidity in the market and also enables rapid execution of orders.
Options allow an investor to reduce risk and provide an improved chance to profit from stock market investments.
The simplest way to explain option trading is that investing in a stock option is basically buying the right to “buy or sell” a stock at a certain price if and when you want to. There is no obligation to exercise the stock option at all.
It is important to remember that buying stock options is completely different from buying stock.
American options can be exercised anytime between the date of purchase and the expiration date.
European options may only be redeemed at the expiration date.
Most exchange-traded stock options are American.
Types of Options
There are two main classes of stock options which are called CALL OPTIONS and PUT OPTIONS.
Both types allow for limitless combinations of pssible option strategies. Profits can be gained, through various strategies, whether stocks move up or down, or stay stagnant.
A third but very different type of option are the Weekly Options which were first introduced in October, 2005, by the Chicago Board Options Exchange (CBOE.O), the largest U.S. options market.
These Weekly Options, or commonly called “Weeklys”, are options listed with approximately one week to expiration, different from traditional options that have a life of months or years
Now, a new type of option, the Mini Option, will be launched on March 18, 2013 by The International Securities Exchange (ISE).
This type of option will permit investors to trade options on 10-share lots rather than the customary 100 shares. This development is a great cog-in-the-wheel of success and profit for the investor!
Mini Options will have the same expiration dates as their standard counterparts, including Weeklies and Quarterlies. Strike prices will also align to those of the standard contracts, as will the quoted bids and offers.
History of Options
To help explain option trading further, let’s take a look at the history of options.
Contracts similar to options have been used since ancient times, approximately 332B.C. where they were used to secure the rights to olive presses.
Early European Options Trading
In London, in as early as the 1690s, puts and ‘refusals’ (calls) first became well-known trading instruments during the reign of William and Mary.
The Origin of American Stock Options
Privileges (or stock options as we know them) were options sold over the counter (OTC) in 19th Century America. Both puts and calls on shares were offered by specialized dealers. American financier, Russell Sage, created these options in 1872. They were not standardized contracts, and had no real pricing model or terms.
The exercise price was fixed at a rounded-off market price on the day or the week that the option was bought. This pricing system was based on sellers simply charging a price they felt was reasonable, and resulted in very inefficient markets. The expiry date was generally three months after purchase.
It was not until 1973 that, with the creation of the Chicago Board of Options Exchange (CBOE), and the invention of the Black-Scholes Option Pricing Model, that call and put options finally became standardized, and available to the general public.
The Options Clearing Corporation (OCC) was also created as a guarantor for all stock options contracts. The OCC guarantees the performance and delivery of every stock option contract.
The American Stock Exchange (AMEX), Philadelphia Stock Exchange (PHLX), and the Pacific Exchange (PCX) all began trading stock options by 1976. (The PCX was demutualized in 2002).
In ConclusionWhile there are many more areas that can help to explain option trading, this is a basic overview of what stock options are, and where and how they started. Back to Stock Options Made Easy from Explain Option Trading