When we talk about trading, stock options are a very popular trading option. With the increase in the number of traders in the market, there is also an increase in options trading. For new traders, an important question is the meaning of stock options and their types. Do you have the same question? Read on to know the answers to this question and more details on stock options.
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What is the meaning of stock options and their types?
Stock options are financial contracts that provide traders with the right, but not the obligation, to buy (call option) or sell (put option) a specific number of shares of a company’s stock at a predetermined price within a specified time frame. These options are traded on stock exchanges, just like stocks, and can be used for various trading and investment strategies. stock options are categorized mainly into two types: “Call Options” and “Put Options.” Each type serves a different purpose and can be used strategically in trading.
Call Options
A call option gives the trader the right to buy a specified number of shares at a predetermined price (known as the “strike price”) before the option’s expiration date. Call options are used when traders anticipate that the price of the underlying stock will rise. By purchasing call options, traders can potentially benefit from price increases without actually owning the stock. If the stock price rises above the strike price before the option’s expiration, traders can exercise the call option and buy the shares at the lower strike price, thereby realizing a profit.
Put Options
A put option gives the trader the right to sell a specified number of shares at a predetermined strike price before the option’s expiration. Put options are used when traders expect the price of the underlying stock to fall. By purchasing put options, traders can potentially profit from price declines. If the stock price drops below the strike price before the option’s expiration, traders can exercise the put option and sell the shares at the higher strike price, locking in a profit.
Some of the key terms that are associated with stock options and their meaning are tabled below.
| Term | Meaning |
| Strike Price | Predetermined price at which the option holder can buy (call) or sell (put) the underlying stock. |
| Expiration Date | The date by which the option must be exercised. If not exercised, it becomes worthless. |
| In the Money | A call option with a strike price below the current stock price, or a put option above it. |
| Out of the Money | A call option with a strike price above the current stock price, or a put option below it. |
| At the Money | A call option with a strike price equal to the current stock price. |
| Premium | The cost of purchasing an option, paid to the option seller. |
| Underlying Assets | The stock to which the option is linked. |
| American Option | Can be exercised anytime before or on the expiration date. |
| European Option | Can only be exercised on the expiration date. |
What are options greeks and why are they important for understanding stock options?
While evaluating stock options, traders use the term option greeks to understand them better. Options Greeks are a set of mathematical measurements that quantify the risk and sensitivity of options to various market factors. These measurements help traders understand how changes in underlying stock price, time, volatility, and other factors can affect the value of their options. For a trader, understanding Options Greeks is crucial as it allows them to make more informed trading decisions and manage their risk effectively.
The various options greeks and their details are mentioned below.
Delta
It measures the change in the option price for a Re.1 change in stock price. A call option’s delta ranges from 0 to 1, while a put option’s delta ranges from -1 to 0. Positive delta indicates a bullish position, negative delta indicates a bearish position.
The formula to calculate the delta is,
Delta (Δ) = ∂V / ∂S
Gamma
It measures the rate of change of delta with respect to stock price. High gamma indicates that the delta will change rapidly in response to stock price movements, making position management more dynamic.
The formula to calculate Gamma is,
Gamma (Γ) = ∂²V / ∂S²
Theta
It measures the change in option price due to the passage of time. Theta indicates time decay and quantifies how much the option’s value will decrease as the expiration date approaches.
The formula to calculate Theta is,
Theta (Θ) = ∂V / ∂t
Vega
It measures the change in the option price for a 1% change in implied volatility. Vega helps traders understand how changes in market volatility impact option prices. Higher vega implies higher sensitivity to volatility changes.
The formula to calculate Vega is,
Vega (V) = ∂V / ∂σ
Rho
It measures the change in the option price for a 1% change in the risk-free interest rate. Rho is generally less significant for short-term options but can impact longer-term options due to interest rate changes.
The formula to calculate Rho is,
Rho (ρ) = ∂V / ∂r
What are the popular stock options trading strategies?
A few popular stock option trading strategies are discussed hereunder.
Covered Call Strategy
This strategy involves holding a long position in a stock and simultaneously selling a call option on the same stock. It’s a conservative strategy used to generate income. If the stock’s price remains relatively stable or rises slightly, the call option may expire worthless, allowing the trader to keep the premium received from selling the call.
Protective Put Strategy
In this strategy, a trader who owns a stock purchases a put option on the same stock. If the stock’s price drops, the put option’s value increases, offsetting potential losses in the stock’s value. It’s a way to hedge against downward movements in the stock’s price.
Long Straddle Strategy
This involves buying both a call option and a put option with the same strike price and expiration date. The goal is to profit from significant price movements in either direction. If the stock price moves significantly, the value of one of the options should offset the loss in the other.
Long Strangle Strategy
Similar to the long straddle, the long strangle involves buying a call option and a put option, but with different strike prices. This strategy also aims to profit from volatility, but it requires a larger price movement to be profitable compared to the long straddle.
Bull Call Spread Strategy
This strategy involves buying a call option with a lower strike price and simultaneously selling a call option with a higher strike price. The goal is to profit from a moderate upward price movement in the underlying stock while reducing the cost of the trade.
Bear Put Spread Strategy
In this strategy, a trader buys a put option with a higher strike price and sells a put option with a lower strike price. The aim is to profit from a moderate downward price movement while mitigating the cost of the trade.
Conclusion
Stock options are part of the derivative market or the secondary market and are widely popular among traders across the globe. Traders need to carefully monitor the volume and price movement of the underlying asset to understand its valuation and the implementing the correct trading strategy.
