What Are Stock Options?

So what are stock options to the average ordinary individual?

In my opinion they don't exist for the average ordinary individual. Stock options are relatively unknown to the rest of the world and understanding stock options takes time.

That's why the goal of this lesson is to give you a basic definition of stock options.

So What are Stock Options and Why Should You Care?

For the sake of simplicity, I'm going to refer to options on stocks only, even though options can be traded on commodities and other securities as well.

"Stock options are contracts; they don't represent ownership in anything. They are merely contracts that grant you certain rights".

Definition of Stock Options: If you buy or own a stock option contract it gives you the "right", but not the "obligation", to buy or sell shares of a stock at a "set price" on or before a given "date" (time period). After this date, your contract expires and your option ceases to exist.

For example, a contract at a country club may grant you the right to use the country club whenever you choose to, but you're not obligated to use it. It's not like they're going to send the country club police to your house and make you go there.

A stock option contract grants you the right to buy or sell a specific stock.

1 stock option contract = 100 shares of a company's stock. So when you buy 1 contract you are buying the right to buy or sell 100 shares of that stock.

I have a one year contract with a local gym here. It gives me the right, but not the obligation, to go to the gym whenever I want for a year. They don't make me go, but if I don't exercise my right to go then I lose the money I paid for this right.

After a year my contract ends and I no longer have the right to workout at that gym.

Well stock option contracts grant you the rights listed above, but you don't have to buy or sell the stock if you don't want to. If you don't exercise the rights of your contract then you simply lose the money paid for the contracts.

I've tried my best to use everyday examples to aid in your learning.

Understanding stock options can be hard at first and it doesn't help that that dictionary definition of stock options reads as follows:

Stock Option: A right to buy or sell specific securities or commodities at a stated price within a specified time.

2 Types of Stock Options or Ways to Profit: Puts and Calls

Understanding stock options becomes easier once you realize that everything boils down to two components: Puts and Calls.

That's it!

Puts and Calls are the only two types of stock options. Everything else is just a variation or combination of these two.

The "Put" option gives its buyer the right, but not the obligation, to "sell" shares of a stock at a specified price on or before a given date.

The "Call" option gives its buyer the right, but not the obligation, to "buy" shares of a stock at a specified price on or before a given date.

The definition of Puts and Calls is given here as an overview. We will go deeper into Puts and Calls in one of the later sessions in this module.

What are Stock Options to the Wall Street Community?

In Wall Street circles stock options are called "derivatives". They are called this because the option contracts are derived or come from stocks.

Your children are derived or come from you. Cheese is derived or comes from milk. Stock options are derived or come from stocks. You can't have the latter without the former.

The only reason cheese exists is because someone wanted another way to consume a milk product. So someone created or derived cheese from milk, it's the same with stock options.

A stock option only exists because someone wants the right to buy or sell a certain stock, so an option contract is created based on that particular stock this person wants to buy.

Another aspect of derivatives (stock options) is that the options price follows the rise and fall of the stock price. When the stock's price rises and falls, the option's price rises and falls.

Don't worry about making sense of derivatives. This information was given in case you hear someone on TV talking about derivatives. Derivatives are highly traded so they are talked about frequently on CNBC.

So what are stock options...they're derivatives.

That's actually their proper name, but you'll hardly hear me use that term. It's too nerdy for me and when it's used it makes understanding stock options that much harder.

Lesson Recap...

An option is a contract that conveys to its holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date. After this given date, the option ceases to exist.

An option contract can be broken down into four components:

  1. Underlying Security - Options are based on an underlying security (stock). That means each stock option is linked to a stock. So, a specific company's stock option is linked to that specific company's stock, and the price of the option will rise and fall with the price of the stock. **Not all stocks have listed stock options**
  2. Right, Not Obligation - Owning an option gives you the right, but not the obligation, to buy or sell the underlying security (the stock) at a specified price.
  3. Specified Price (strike price) - Owning an option gives you the right to buy or sell a stock at a specified price. Listed options have been standardized to represent specified stock prices.
  4. Time - Your right to buy, or sell, the underlying stock expires on a given date. The period of time the option exists is also known as the life of the option. After that date the option ceases to exist, the stock does not go away but the option does.

"Stock options" are often called derivatives because they are derived from stock prices.

Options trading is by far the most cost-effective way of trading the stock market. And if done correctly it's also one of the smartest ways to invest.

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I don't know what has brought you to my page. Maybe you are interested in options to help you reduce the risk of your other stock market holdings.

Maybe you are looking for a way to generate a little additional income for retirement. Or maybe you've just heard about options, you're not sure what they are, and you want a simple step-by-step guide to understanding them and getting started with them.

I have no idea if options are even right for you, but I do promise to show you what has worked for me and the exact steps I've taken to use them to earn additional income, protect my investments, and to experience freedom in my life.

If you want to learn more, I invite you to download FREE video case study on how to trade options like Warren Buffett.

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