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How to Trade Options » EXPLAIN OPTION TRADING » Stock Option Contracts

Stock Option Contracts

 A Brief Definition of Stock Option Contracts and How They are Priced

Stock option contracts are effectively a legal arrangement that allows the holder to buy or sell an agreed security or asset (called “the underlying”) for an agreed price, up to an agreed expiration date. The agreed price is called the “strike price”.

There are only two types of stock option contracts:

  • Call Options
  • Put Options

Regular traditional option contracts, as opposed to more “exotic” options, are called a “vanilla options”. The more exotic option contracts are called binary options and these have a very different pricing model and reward structure.

Stock option contracts include a number of pricing components, namely:

The greeks
– there are 5 letters of the greek alphabet, each representing a factor in options pricing models. These are the delta, gamma, theta, vega and rho. For further reading, visit our page on the option greeks.

Implied Volatility
– sometimes, due to forces of supply and demand, stock option contracts can become overpriced or underpriced, relative to what would be consider ‘normal’. When this happens, this additional factor is attributed to stock options implied volatility.

Intrinsic Value
– when the strike price of the option, relative to the price of the underlying security, is favourable, the options are said to be “in the money”. When this happens, the options have intrinsic value. Basically it means that, if we had reached options expiration date, the option contracts would still be worth something.

Time Value
– when the strike price of the option, relative to the price of the underlying security, is UNfavourable, the options are said to be “out of the money”. The options have NO intrinsic value. This means that, if we had reached options expiration date, the option contracts would expire worthless. But for the duration of time up UNTIL option expiration date, out of the money stock option contracts still have some value. This value represents ONLY the probability that by expiration date, the options will be “in the money”.

In most countries, one stock options contract allows the holder to control the fortunes of 100 underlying shares. However, you can also trade with options on commodity futures, indexes and foreign currencies, in which case, the volume of the underlying assets varies.

Stock Option Contracts Example

A trader believes that the price of a stock will rise from its current price of $40 to a level nearing $100. Rather than purchasing the stock itself, she can purchase a call option for a fraction of the price at a strike anywhere between $40 and $100. If the stock does indeed rise to $100, and assuming the call option was bought at a strike of $75, the holder stands to gain $25 per share on the contract, minus any premiums paid for the option itself.

 

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Filed Under: EXPLAIN OPTION TRADING Tagged With: call options, delta, gamma, implied volatility, intrinsic value, options theta, put options, rho, the greeks, theta, time value, vega

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DISCLAIMER: All stock options trading and technical analysis information on this website is for educational purposes only. While it is believed to be accurate, it should not be considered solely reliable for use in making actual investment decisions. This is neither a solicitation nor an offer to Buy/Sell futures or options. Futures and options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in this video or on this website. Please read "Characteristics and Risks of Standardized Options" before investing in options. CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVERCOMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.