A stock option is a financial instrument that gives the right, but not the obligation, to buy or sell a stock at a set price within a specific time frame.
Understanding stock options
Stock options are divided into two primary categories known as call options and put options. A call option provides the right to buy a stock at a specified price, which is called the strike price. A put option provides the right to sell the stock at the strike price. Investors pay an upfront fee called a premium to acquire these contracts. The premium is the maximum amount a buyer can lose on the trade if the stock price does not move in the anticipated direction.
The rules governing when an investor can use a stock option depend on the execution style of the contract. Global financial markets generally utilize two formats: American options and European options. These names refer to the execution rules rather than geographic restrictions, and both styles trade on international exchanges. American options allow the holder to exercise the contract at any point before the expiration date. European options restrict the holder to exercising the contract only on the exact expiration date.
Elephants use stock options to execute specific trading strategies. Some investors buy options to hedge existing portfolios against unexpected market downturns. Others use them to speculate on the future price movements of the underlying stock without committing the capital required to purchase the shares outright. Sellers of options collect the premium up front and assume the obligation to fulfill the contract if the buyer decides to exercise their right.
Example
Suppose an investor named Barnaby the Elephant expects the stock of Peanut Farms Ltd to rise over the next month. The stock currently trades at $50 per share. Barnaby buys a call option for a premium of $2 per share with a strike price of $55 and an expiration date one month away. A standard options contract represents 100 shares, so Barnaby pays a total premium of $200. If the stock price jumps to $65 before the expiration date, Barnaby exercises his right to buy the shares at the $55 strike price. He secures shares worth $65 each, leaving him with a profit after accounting for his initial premium cost. If the stock price remains below $55, Barnaby lets the option expire and loses the $200 premium.