Ben Ridgeway Ben Ridgeway
Sales Trader, Client Trading Services, Saxo Capital Markets
25 July 2015

What are Stock Options and how do they work?

Stock Options are a versatile tool for traders. Here are the basics to help you consider whether they could be a valuable addition to your trading strategy.

​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​What are Stock Options?

It is a contract between two parties in which the buyer (holder) has the right – but not the obligation – to buy or sell a specified, underlying financial instrument to/from the option seller (writer) at a pre-determined price, within a fixed period of time.

In the case of Stock Options, the underlying financial instrument is an equity stock or exchange-traded fund (ETF). UK stock option contracts represent 1000 shares of the underlying instrument whereas US and European stock options represent 100. Other global regions’ equity option exchanges may also differ in this sense.

What is a 'Call' and what is a 'Put'?

Call Options give the holder the right (but not the obligation) to BUY the stock from the writer, who is obliged to sell at the contract price.

Put Options give the holder the right (but not the obligation) to SELL the stock to the writer, who is obliged to buy at the contract price.

 

What's the benefit for my p​​​ortfolio?

Stock Options are versatile tools. Most basic benefits are that they can:

  • Hedge losses

If a trader is worried that the share price of a stock they hold is about to drop, they could buy a Put Option to 'lock-in' a set price.

If the share price of that stock does fall, the trader has set a 'floor' price for those shares by using a 'Put' on a Stock Option, and would sell at that set price to the writer. If those shares have increased in price, the trader is not obliged to sell, so benefits from the higher stock price.

  • Reduce costs, boost profits

A trader can use stock options to benefit from the movements in a stock's price at a fraction of the cost of owning the stock. The cost of an equity option contract (which may, for example, cover 100 shares) is usually far cheaper than paying the full share price to hold 100 shares.

By using a Call Option, a trader can set the strike price at where they think the share price will rise to. If the share price rises, the value of the option increases, providing a higher return for the stock option investor than the direct stock investor.

What are the risks?

​Stock Options ​​are highly-leveraged products offering attractive returns to investors ​at a fraction of the cost of ​investing in traditional stocks. Higher leverage carries ​​greater risks, so you should ​​make sure you completely understand the advantages and disadvantages of investing in options before you start ​​actively trading. 

Options' expiration​​price volatility and possible changes to interest rates and dividends are ​some of the most common risk factors you should consider when developing your investment strategy.

Can I exercise a stock option before the expiration date?

Standard expiration dates are typically up to one year, although LEAPS (Long-Term Equity AnticiPation Securities) have longer expiration dates of up to three years. There are two 'styles' of options available:

  1. American Style, which can be exercised at any point before the expiration date
  2. European Style, which can only be exercised on the day of expiration

Please note that Stock Options are always exercised in American Style and make sure you check with your broker about their specific cut-off times for exercising Stock Option contracts. For most equity options, shares of stock must be exchanged between parties at the time of contract exercise, but most index options are cash settled, with money being exchanged at time of contract exercise.

To find out what Stock Options are available on the Saxo platform, click here.

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