How To Trade Options Primer

Many investors ask about the terminology of options and the difference between types of options. Here I share some background o the fundamentals of option trading. Bonus: An active option trade is shown below for our Covered Call of the Week.

An option is a standardized contract originated by the Options Clearing Corporation (OCC) that is exchange-listed. A stock option is the legal right, but not obligation, to buy (calls) or sell (puts) shares of a specific stock, which is known as the underlying stock, for a fixed time and a fixed price. Stock options have two main characteristics:

Fixed Price: an option give the holder the right to buy or sell at a fixed price. This price is known as an exercise price or strike price (or just “strike”).

Limited Life: an option is good for only a specific period of time, then expires. If it expires without being exercised, it is said to “expire worthless”.

The Two Types of Options

There are two types of options to be used in your option strategy for various trades based on the prediction of the investor.

Calls: the right, but not the obligation, to buy the underlying stock.

Puts: The right, but not the obligation, to sell the underlying stock.

(Click on image to enlarge)

Underlying Stock – these are the shares of stock that underlie (are subject to) a stock option. The underlying stock also can be an Exchange-Traded Fund (ETF) instead of a stock.

Option Contract – each exchange-listed call or put contract normally covers 100 shares. The only exception would be for a stock or reverse split, merger or other corporate recapitalization, which can result in an adjustment to the terms of an option contracts. There are over-the-counter options, but they are a different subject and not covered in this article.

Option Trading – standardized options contracts are exchange-listed and traded on the different U.S. option exchanges.

Expiration – stock options (equity options) expire on the Saturday following the 3rd Friday of each month and that Friday is the last day on which those options can trade. If the 3rd Friday is a holiday, the last trading day will be the Thursday before. Some brokerage firms institute a Friday deadline for notice of exercise by retail customers so be clear on whether you can exercise options on expiration day. Be aware that options you have sold can be exercised on expiration day.

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