Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.
Options are derivatives , which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds ETFs , government securities, foreign currencies or commodities like agricultural or industrial products.
Stock options contracts are for shares of the underlying stock - an exception would be when there are adjustments for stock splits or mergers. Options are traded on securities marketplaces among institutional investors, individual investors, and professional traders and trades can be for one contract or for many. Fractional contracts are not traded. An option contract is defined by the following elements: Although options share many similarities with regular equities, there are also some important differences.
Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date.
This is not true for the seller of an option. An equity option allows investors to fix the price, for a specific period of time, at which they can purchase or sell shares of an equity for a premium price - which is only a percentage of what they would pay to own the equity outright.
This leverage means that investors may be able to increase their potential reward from a price movement by using options. Although the dollar amount gained on the stock investment is greater than the option investment, the percentage return is much greater with options than with stock. Leverage also has downside implications. If the stock does not rise as anticipated or falls during the life of the option, leverage will magnify the investment's percentage loss.
Investors should take note, however, that as an option buyer, the most you can lose is the premium amount paid for the option. Other key differences between options and regular equities are in how the investment is structured: Enter up to 25 symbols separated by commas or spaces in the text box below.
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Limited Risk for Buyer Unlike other investments where the risks may have no limit, options offer a known risk to buyers. Leverage Investment An equity option allows investors to fix the price, for a specific period of time, at which they can purchase or sell shares of an equity for a premium price - which is only a percentage of what they would pay to own the equity outright.
Regular equities can be held indefinitely by a buyer, whereas options have an expiration date. If an out-of-the-money option is not exercised on or before expiration, it no longer exists and expires worthless.
There are no physical certificates for stock options as there are for regular equities. Regular equities are issued in a fixed number by the issuing company, while there is no limit to the number of options that can be traded on an underlying equity.
The number of options that are traded is based only on how many investors are interested in trading the right to buy or sell that particular equity. Unlike equity ownership, owning an option does not confer voting rights, dividends or ownership of any share of a company unless the option is exercised.
The greatest similarity is the way in which option and stock transactions are handled: Options are listed and traded on national SEC-regulated marketplaces similar to regular equities.
Orders for options are transacted through brokers with bids to buy and offers to sell just like equity buy and sell orders. Buyers and sellers of options and equities can track performance and follow transactions through the marketplaces on which they trade.
This site discusses exchange-traded options issued by the Options Clearing Corporation. No statement on this site is to be construed as a recommendation to purchase or sell a security, or to provide investment advice. Options involve risks and are not suitable for all investors. Prior to buying or selling an option, a person must receive and review a copy of Characteristics and Risks of Standardized Options published by The Options Clearing Corporation.
Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.