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Many traders think of a position in stock options as a stock substitute that has a higher leverage and less required capital. After all, options can be used to bet on the direction of a stock’s price, just like the stock itself. However, options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn.
Two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date.
One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: a buyer and a seller. So, for every call or put option purchased, there is always someone else selling it.
When individuals sell options, they effectively create a security that didn’t exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.
Trading stocks can be compared to gambling in a casino, where you are betting against the house, so if all the customers have an incredible string of luck, they could all win. Trading options is more like betting on horses at the racetrack. There they use parimutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer’s gain is the option seller’s loss and vice versa: any payoff diagram for an option purchase must be the mirror image of the seller’s payoff diagram.
When the strike price of a call option is above the current price of the stock, the call is out of the money; when the strike price is below the stock’s price it is in the money. Put options are the exact opposite, being out of the money when the strike price is below the stock price and in the money when the strike price is above the stock price.
The Bottom Line
Most option traders use options as part of a larger strategy based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them.
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