So you are interested in stock options. Well, you have come to the right place! This article will give you a basic understanding about stock options. We will cover some easy to understand theory and teach you some of the commonly used terminology used in the stock options world. Then we will run through a simple example and then you will learn a couple of different option types as well as what affects their price. So grab a cup of coffee and get ready to learn about options trading for beginners.
What is a Stock Option?
Think of a stock option as a contract to buy stock at a set price. This contract lasts for a set period of time and the holder of this contract can enact this contract at any time, during this time period. Stock options are a very common form of employee compensation packages.
One reason for the popularity of stock options is that the employee does not pay tax when issued with stock options. This is unlike being issued with stock where the employee will need to pay tax based on the value of the stock.
Are you following along? Great. Let’s talk about the terminology of stock options. When stock options are issued, the set price, in the contract, is referred to as the “strike price.” So, if you were to hold stock options for $1 a share, then the “strike price” would be $1.
Let’s say you want to use your contract and buy the stock at the strike price. When you use the contract and buy the stock, this is called “exercising” an option. You can “exercise” your option at any time within the set time period of the contract.
Let’s take a look at an example and use the terminology. Pretend you hold stock options for 1000 shares of Nestle with a strike price of $1. You might look at the stock and see that Nestle stock is selling for $2 a share. You could “exercise” your stock options and buy the Nestle stock at the “strike price.”
This would mean you would buy the 1000 shares for $1000. You could then sell your Nestle shares on the stock market for $2000. This would make you a profit of $1000. Of course you would need to pay taxes on your profits but we won’t go into that right now because this is just a guide to stock options for beginners.
If you are up to this point of the article, you will now have a basic understanding of stock options for beginners. Let’s now talk about options trading for beginners. We have previously spoken about exercising options but you can also sell the options themselves. For example, if you have the right to buy 100 shares of stock, you can sell that right to someone else. This means that they now have the right to buy that stock at the strike price.
Before I tell you about option types, you will need to know that each option contract encompasses 100 shares of stock. This means that if you wanted the right to buy 1000 shares of stock, you would need 10 option contracts.
In the world of options trading, you will come across what is called a “Call option.” As has already been discussed, a “call option” gives you the right to buy stock at an agreed upon strike price.
Call options have a set time period in which the options can be exercised. The date that a call option ends is know as the “expiration date.” Now, in order to obtain call options, you will have to pay a fee. The fee for buying call options is called the “premium.” This fee gives you the right to the call option, so you can buy the stock at the strike price before the expiration date.
The 3 Main Factors that will Influence the Premium Price
1. The Strike Price.
When the strike price is lower, the premium will be higher. This is because there is a higher likelihood that a good profit can be made from this option.
2. Duration of the Option.
The longer the time before the expiration date, the higher the premium will be. Again, this is because there is a higher likelihood that a good profit can be made from this option.
3. The Volatility of the Stock Price
The volatility of the stock price will influence the premium.
A put option gives you the right to sell certain stock at a set price during a set time period. Again, the agreed upon price is called the “strike price” and the date the option expires is called the expiration date. It is important to note that you actually need to own the stock in order to sell it. Like this article has mentioned before, in order to obtain a put option, you need to pay a fee that is known as a “premium.” Put options are commonly used to protect a stock investment.
The 3 Main Factors that Influence the Price of the Premium.
1. The Strike Price
The higher the strike price, the higher the premium. This is the opposite principle of the call option.
2. Duration of the Option
The longer the time period of the option the higher the premium will be
3. The Volatility of the Stock Price.
Again, the volatility of the stock price will influence the premium.
By now, you should have a great understanding of options trading for beginners and might want to learn about options strategies or ways to trade options. You have now covered the theory behind options along with the most commonly used terminology. Does “strike price” ring a bell? We have also introduced you to call and put options and given you an introduction into the factors that affect the price of option premiums. You are well on your way to becoming an options trading kingpin! We hope you have enjoyed The Ultimate Guide to Stock Options for Beginners.
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