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Stock Options

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Options are securities that make it possible to invest in stocks without actually owning the shares. Options on stock are bought to speculate on price movement. Stock options are themselves securities and can be traded in financial markets. An option to buy a stock is known as a call option or just a call. Options to sell securities are known as put options or just puts.

Options are the most important example of a class of financial assets known as derivative securities. A derivative is so named because it derives its value from the price of another underlying security, in this case the optioned stock.

Investors are interested in stock options because they provide speculative leverage, a term applied to any technique that amplifies the return on an investment. An option's leverage comes from the fact that the return on the investment can be many times larger than the return on the underlying stock.

Writing an Option

There are two parties to a contract, a buyer and a seller. The first person to sell an option contract is the person who creates it by agreeing to sell the stock at the strike price. He or she is said to write an option and is called the option writer.

Once the option is written, the option contract becomes a security and the writer sells it to the first option buyer, who may sell the contract to someone else later on. No matter how many times the option is sold, the writer remains bound by the contract to sell or buy the underlying stock to the current option owner at the specified price.

Options are written either covered or naked. With a covered option, the writer owns the underlying stock at the time the option is written. Someone who writes a naked option doesn't own the underlying stock at the time he or she writes the option and therefore faces more risk.

Intrinsic Value of an Option

If a stock's current price is below the strike price in the case of a call, or above the strike price in the case of a put, we say that the option is "out of the money" because the option contract buyer could not make any money exercising the contract. If the stock's price is above the strike price in the case of a call, or below the strike price in the case of a put, we say that the option is "in the money" because the option contract buyer could make money exercising the contract.

In general, the option's intrinsic value is the difference between the underlying stock's price and the option's strike price. Investors are willing to pay premiums over intrinsic value for stock options because of the chance that they will earn even more profit. Option premium is the difference between the intrinsic value of the option and the option's price. The exact amount of a particular option's premium above intrinsic value depends on the stock's volatility, the time until expiration, and the attitude of the market about the underlying company.

Option Expiration

It's important to keep in mind that options are exercisable over only a limited period at the end of which they expire and become worthless. That makes option investing very risky. For example, if an option is purchased "out of the money" and the option never gets "in the money," the option expires, worthless. The buyer loses the entire price paid for it.

If an option is purchased at a price that includes a positive intrinsic value and the underlying stock goes down in value, the option buyer's loss at expiration is the time premium paid plus the decrease in intrinsic value. As its expiration date approaches, any option's time premium shrinks to virtually nothing. Notice that anyone owning an option with a positive intrinsic value just before expiration must act quickly to avoid losing value.