Stock Option Basics: -
The Important Elements of Stock Options

Stock Option Basics

The main focus of this article is to impart knowledge on stock option basics covering terms such as delta, strike price, theta etc.

Option Contract: An option contract is essentially an agreement between a buyer and a seller in which the buyer has the right but not the obligation to exercise the contract.

At the other end of the trade the sell is obligated (but do not have the right) to perform according to the contract, So the question here is: why would anybody want to be the sell given the obligation?

Answer: The seller is being paid to undertake the risk. The amount received by the seller is termed as premium. 

The Delta: Option prices are greatly affected by the underlying stock prices. However, depending on a few factors (such as proximity to strike price, time to expiration etc) the magnitude of the change in option price can vary for different options. The term that is used to describe this is call delta, which is a measure of the change in option prices due to the change in the stock price that the option is based upon.

The Strike Price:. One of the important components of understanding stock option basics is knowing the strike price, the strike price s essentially the price agreed upon by both parties when the option is exercised. As a rule of thumb if you are an option seller it is a good idea to sell out-of-money options and if you are the buyer, to buy options that are in- the-money.

Vega and Theta: Apart from delta and strike price, the next two important factors that influence the price of option are volatility (vega) and the time to expiration (theta). A higher volatility will result in higher option price. This usually happens when market is anticipating something about the stock say, pending a result release or say FDA approval for a drug company. Theta is essentially the time decay of the option as it approaches the expiration date.

The Basic Building Block of Option Type

The two types of options that can be used in various complex positions are essentially made up to two types of options, namely the call and the put options, described as follows:

The Call Option: A call option gives the owner of the call the right but not the obligation to buy the underlying shares at a certain predetermined price (strike price) before a certain predetermined date (expiration date).

The Put Option: A put option gives the owner of the call the right but not the obligation to sell the underlying shares at a certain predetermined price (strike price) before a certain predetermined date (expiration date).

Difference between Option and Futures Contract

To begin with, both options and futures are leverage instruments, having said that, they are actually quite different animals.

Futures are exchanged traded, standardized contract (as compared to Forward contracts which are based on what's agreed upon between two parties) that requires the delivery of the specific quantity of the underlying (commodity or financial assets) at a certain specified dated, i.e. both parties of the contract are required to perform according to the contract. Options, however, only created an obligation on one party but confer the right to another party.

Stock Option Basics -  Comparing the Difference between Option & Stock Trading.

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