Call And Put Option: Option Trading Basic Fundamental Theory

Submitted by: Alexander Chong

It is very common that stock is transacted in blocks divisible by 100, which is called a round lot. A round lot has become a standard trading unit on the public exchanges for quite sometime ago. In stock market, we have the right to buy and sell an unlimited number of shares as long as there are people are willing to sell and we are willing to buy at the price that the seller has fixed. Usually, for a brokerage firm, they set their commission for a transaction for minimum 100 units of share at a certain price. If we buy less than 100 units of share, they still impose us this commission. For an example, if we buy 100 units share and pay the brokerage firm USD 30 for the buy and sell transactions, they also charge us that amount: USD 30 also, if we only buy and sell 1 units of share.

 

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The amount of commission that the brokerage firm charges for the stock transaction is varied from one and other. Some brokerage firm may charge less but they require you to trade a lot in one transaction. So, each unit of option is representing 100 units of share.

In fact, there are two types of options that are call and put option. Call option gives its owner the right to buy 100 units of share of a company at a specified price that has been agreed between the call option owner and the seller within certain period of time. So, within this period of time, if the stock price goes up, the call option price will also go up and vice versa. The second type of option is put option. This option gives its owner the right to sell 100 units of share of a company at a specified price that has been agreed between the put option owner and the seller within certain period of time. Put option seems like the opposite of call option. If the stock price goes up within this period of time, the put option price will go down. Either call or put option can be bought or sold. As long as there are people willing to sell, there will be people willing to buy. There are four permutations that are possible exist during the transaction of an option. The first one is buying a call option meaning that buy the right for yourself to buy 100 units of share. Second is selling call option meaning that sell the right to buy 100 units share from you to someone else. The third one is buying a put option meaning that buy the right for yourself to sell 100 units of shares. The last one is selling a put option meaning that sell the right to sell 100 units of share to you to someone else.

The other way to make these differences clearer is always remember that the call option buyer hopes the stock price will go up and the put option buyer looking for the price per share to fall. For the opposite side, a call option seller is hoping the stock price will maintain or fall. Whereas, put option seller is hoping that the stock price will go up. If the option buyer no matter dealing with the calls or puts option is correctly predicting the price movement of the stock, then they will gain profit from their action. For option, there is another obstacle we have to face besides estimating the direction of the stock price movement. This obstacle is that the change of the stock price has to be taken place before the deadline of the option. As a stockholder, we may be able to predict a stock’s long-term prospects by waiting for a long-term change of the stock. However, for option holder, we may not have that kind of opportunity. This is because options are finite; they will lose all their value within a short period of time, usually within a few months. However, it has long-term options that can last up to one to three years. Due to this limitation, time will be an important factor to determine whether an option buyer can earn a profit or not.

Foremost, option is granting the buyer an intangible right to buy or sell 100 units of share at an agreed price between the buyer and seller of the option. Therefore, option is just an agreement regarding to 100 units of share of a specific stock and to a specific price per share. Therefore, if the buyer buys an option at the wrong timing, then, the buyer will not able to make any profit. Wrong timing means that the stock price does not move or does not move substantially when the deadline has arrived. When we buy a call option, it seems like we are agreeing that we are willing to pay the price that being asked to acquire a contractual right. The right provided that we may buy 100 units of share of stock at a specified fixed price per share, and this right exists at the time we purchased the option until the deadline of the option. Within the time we purchased the option until the deadline of the option, if the stock price goes up more than the fixed price indicated in the option agreement, this call option will become more valuable. Just think that we buy a call option that granting us the right to buy 100 units of shares at the price of USD 70 per share. Let said before the option deadline, the stock price has gone up to USD 90 per share. As an owner of this call option, we have the right to buy 100 units of share at USD 70, which is USD 20 less than the current market price. This is the situation when stock market price is more than the fixed contractual price indicated in the call option contract. In this example, we as buyer would have the right to buy 100 units share, which is USD 20 less than current market price. Although we own the right to do so, we may unnecessarily to execute our right. For an example, how about if the stock price has gone down to USD 50. We would not have to buy shares at the fixed price of USD 70 and we could select not to take any action.




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About the Author: Alexander Chong Author of “Workable Option Trading Strategies” http://www.makemoneystocks.com/

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