What are Stock Options?

You have a bakery and you need to have eggs supplied to you in the next 3 months. You are aware that the cold season will produce fewer eggs in 3 months. You suspect that the price of the eggs is going to increase because of the cold weather.

In order to ensure that you get a certain price for the eggs, you enter into an agreement with an egg supplier to buy the eggs for a particular price before or at the 3 months. The egg supplier agrees if you give him a certain amount. You then have the ability to buy the eggs at the price you wish after the 3 months if you decide to do so.

You have entered into a basic options contract. A stock option is the same type of contract where you are buying the right but not the obligation to buy a stock or share of a company at a particular price, on or before the agreed date. The owner of the stock is accepting the obligation to sell the stock at your price for a small fee.

Why Trade in Stock Options?

It is easy to see why someone would buy options in a stock. If you think that the price of a stock is undervalued now is likely to go up after a particular period, you would buy an option. Your hope is that the price of the stock will go higher than the cost of the buying the stock plus the cost of the option. You would then sell the stock at the market price for a profit.

The owner of the stock on the other hand is hoping that the stock will not reach the price that you have quoted. In the case that this does not happen, the owner of the stock will profit from the cost of the option, which you had paid to him.

An example: An investor buys call options on Barclays Bank with a strike price (the expected price) of 50 pounds. The current price of Barclays Bank is 40 pounds and the cost of the call is 5 pounds.

If the stock price of Barclays rises above the total cost of the option (50 + 5= 55), then the call buyer will exercise his right to the option and sell the stock to the open market for a profit.

The seller of the option will benefit from the rise in the price from 40 pounds to 50 pounds, plus the 5 pounds that he got from selling the call. The option seller profits from the call price of 5 pounds if the 55-pound stock price is not reached.

It is easy to see why option sellers love stock options. They are likely to profit whichever way the market goes. Option buying on the other hand is very risky but the rewards are huge. Investors have found that it is cheaper to buy options than buy shares at the market price. This gives the investor more funds to invest in other projects instead of putting all his money in one or two shares.