Stock Market 101: Options Trading

Overview:

1. What is Options Trading?

2. Types of Options Trading

3. What do Expiration Dates Mean?

What is Options Trading?

Options are financial derivatives, meaning that they derive their value from the underlying security or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock at a pre-determined price. This is unlike Futures because you are not forced to buy or sell at any particular time. One important difference between stocks and options is that stocks give you a small piece of ownership in a company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. The price of an option is called the premium. The buyer of an option can't lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.

Types of Options

There are two types of options. Calls and Puts. When you buy a call option, you have the ability to purchase a stock at a set price, called the strike price, any time before the option expires. When you buy a put option, you have the ability to sell a stock at the strike price any time before the expiration date. Keep in mind that you are never obligated to buy or sell like in Futures. There are also two basic styles of options: American and European. An American-style option can be exercised at any time between the date of purchase and the expiration date. A European-style option can only be exercised on the expiration date.

Expiration Dates

All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called long-term equity anticipation securities (LEAPS), are also available on many stocks. These can have expiration dates up to three years from the listing date.

Options expire at market close on Friday, unless it falls on a market holiday, in which case expiration is moved back one business day. Monthly options expire on the third Friday of the expiration month, while weekly options expire on each of the other Fridays in a month.