What is a Stock Option?

A stock option is a contract between two parties that gives the buyer the right to buy or sell underlying stocksStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. at a predetermined price and within a specified time period.

A seller of the stock option is called an option writer, where the seller is paid a premium from the contract purchased by the buyer.

Stock Option Types

There are two types of stock options:

• A stock call option, which grants the purchaser the right but not the obligation to buy stock. A call option will increase in value when the underlying stock price rises.
• A stock put option, which grants the buyer the right to sell stock short. A put option will increase in value when the underlying stock price drops.

Investment bankers Bulge Bracket Investment BanksBulge Bracket investment banks are the top global investment banks. The list includes companies such as Goldman Sachs, Morgan Stanley, BAML, and JP Morgan. What is a Bulge Bracket Investment Bank andmay purchase either of these two types of options individually or in conjunction with each other to apply certain trading techniques, such as a covered call.

Strike Price

Stock options come with a pre-determined price, called a strike price. InvestorsList of Top Investment BanksList of the top 100 investment banks in the world sorted alphabetically. Top investment banks on the list are Goldman Sachs, Morgan Stanley, BAML, JP Morgan, Blackstone, Rothschild, Scotiabank, RBC, UBS, Wells Fargo, Deutsche Bank, Citi, Macquarie, HSBC, ICBC, Credit Suisse, Bank of America Merril Lynch can purchase call AAPL contracts at the strike price of $108, for example, even though the current market price is $110. Alternatively, they can purchase the call option at a strike price of $113.

In the above example, an option strike price of $108 is called in-the-money, and the strike price $113 is out-of-the-money. In-the-money options, when exercised, result in a profit, while out-of-the-money options, when exercised, will result in a loss.

Settlement/Expiration Dates

Each option has a different expiration date and rule for settlement. There are two option styles in the markets.

• An American-style option which allows the holder of the option to exercise the call/put option any time before expiration
• A European-style option which only allows the option to be exercised on the expiration date.

In the past, when the holder of an option exercised his right, the transaction was processed and the certificates of stocks delivered to the holder. In the modern market, all settlements occur in cash, based on the value of the underlying stock.

Example

Mr. A purchases AAPL November 2016 call options with a strike price of $108. The option contract premium costs $223 for one contract of 100 shares. AAPL, at the time of purchase, stood at $109.10. If the option exercised, Mr. A would get 100 AAPL shares at $108 the next trading day.

The next day, AAPL opened at $109.20. If Mr. A decided to sell the shares at market price, his profit is ($109.20 – $108)*100 – $223 = -$103 (This calculation does not account for commission and transaction fees; each broker might have different fees & commission structures).

Additional resources

To learn more about stocks and investing, check out the following resources from CFI:

• What is a Stock?StockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably.
• Investment BankingInvestment Banking in IndiaLearn about investment banking in India. We list the top investment banks in India and outline how to get a job as analyst or associate. The history of investment banking in India traces back to when European merchant banks first established trading houses in the region in the 19th century.
• Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows
• Quid Pro QuoQuid Pro QuoThe term quid pro quo refers to an exchange of goods or services between two parties when something of equal value is expected to be given in return.
• Exchange-Traded FundsExchange Traded Fund (ETF)An Exchange Traded Fund (ETF) is a popular investment vehicle where portfolios can be more flexible and diversified across a broad range of all the available asset classes. Learn about various types of ETFs by reading this guide.