In the past decade, the popularity of stock options has exploded.
Online trading platforms have injected liquidity into the options market and made it easily-accessible to retail traders. But many stock traders (and even some options traders) may not fully understand what exactly a stock option is.
An option is typically a contract to buy or sell 100 shares of a stock at a certain price on a certain future date.
Options that grant you the right to buy shares are called call options or “calls.” The price at which you are entitled to purchase the shares is called the strike price of the option.
Options that grant you the right to sell shares are called put options, or “puts.”
If you anticipate that a stock's share price will rise, you would look for call options to buy with strike prices below your target price.
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If you predict that a stock's share price will fall, you could potentially profit by buying put options with a strike price above your target price.
Most options traders don’t actually hold the contracts until they expire and never exercise the contract to buy or sell shares of stocks.
If they aren’t held to expiration, options simply trade up and down every day like stocks.
Options can be a useful way to hedge against core portfolio stock holdings, and they can provide major leverage for short-term trades. However, they can also be extremely volatile and risky.
In addition, unlike stocks, options are not directly tied to a real-world company and have no value if they expire out-of-the money.
That means that while stocks rarely go to $0, options frequently do.
For traders that understand the risks associated with option trading, options can be a useful and profitable trading tool.
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