Some financial traders like to think that stock options are simply a substitute for stock trading that has more leverage and requires less capital. This is based on the fact that options can be used to gamble on a direction a stock price will move, much like trading the stocks themselves. Purchasing options, however, is very different than trading stocks. Options have different characteristics and require a different knowledge set. In addition, options use unique terminology.
Options come in two general types: call options and put options. Call options grant the purchaser the right to purchase a stock, or other asset, at a pre-negotiated strike price on or before the expiration. Put options grant the purchaser the right to sell a stock or asset at the strike price on or before the expiration date of the option. In neither type is the purchaser under any obligation to buy or sell the underlying stock.
Perhaps the most important difference between options and stocks is that stocks give the holder partial ownership in a corporation. Options are only a financial tool that affords the holder the right to buy or sell a stock at a pre-negotiated price should it be in their favour. Options always involve two parties: the buyer and the seller. For every option bought, there is always a seller and vice-versa.
The sale of options is unique in that it effectively creates a new security that did not previously exist. The seller of an option is often referred to as the option writer. The writer of the option is essentially agreeing that at some time in the future the buyer may exercise the option, creating an obligation for the writer to complete a stock transaction with the option holder at the agreed-upon price.
One analogy that is often made to show people the difference between stocks and options is in the world of gambling. Trading stocks can be thought of as casino gambling, where the gambler is betting directly against the house. There is no relation between the gambler and the other gamblers. Purchasing options is more like gambling on horse races. Horse races use a pari-mutuel gambling system where the odds are determined by the bets of the other gamblers, creating a situation where the gambler is betting against all the other gamblers instead of against the house.
The price at which an option is purchased is the premium. The premium represents the maximum loss the buyer can take by purchasing the option. No matter what happens to the underlying stock, in the worst case scenario, the option has no value and is left to expire without exercising the right to buy or sell it granted. On the other hand, the potential profit that can be made from an option is unlimited.
The seller of the option bases the premium on the risk of whether or not the option will be exercised by the buyer or, if exercised, the amount from the stock purchase or sale will be less than the premium. The risk is much greater for the seller because the amount of the potential loss to the seller is unlimited.
Types of Options
Two basic styles of options are available for Australian investors: American-style options and European-style options. The difference between the two is when they can be exercised. American-style options can be exercised at any time before the expiration date. European-style options can only be exercised on the expiration date. American-style options are the most popular because they allow for greater flexibility. However, many index options are available only as European-style.