In order to understand stock options, we first need to grasp the basics relating to stock markets, and the mechanism of stock trade. Stock options are contracts to purchase or sell stocks. Here's the explanation of such options.
Stock Options Basics
Stock of companies is principally the common stock or capital that contributes to raise the capital for a company's operations. Stock essentially consists of several parts and types of financial instruments like, shares, which are the most common ones, bonds, securities, preferential share capital, employee shares, debentures and other secured investments.
These instruments are freely trade able through many sources, though the stock market is used as a place of trade. Since stocks are traded in the market they tend to have two types of prices, namely, face value or issue value, and market value. Due to the dynamic and ever-changing nature of market values, concepts such as stock options have come into being.
A stock option is a contract where a person can buy a certain security from the current owner of the security. However, he is not under obligation to buy, as he can simply refuse. When it comes to stock options there are some clauses that can be included in the contract.
For example, a clause may state that the option can be brought at a specified constant price within a specified time period. The market price does not get considered in such a situation. It must be noted that there is no obligation in exercising stock options.
A person may simply opt not to exercise the option, upon which the option contract becomes useless after the end of the time period. Overall, a stock option is an obligation on the seller, or current owner to part with the stock and sell it.
Call and Put
Now, when it comes to stock options, there are two classifications within. The call option and the put option. Here are the definitions:
✦ A call option is a contract that gives the holder of the contract a right to buy at a certain (pre-decided) price within a said time period. Such a contract is made by the investor with the hope the market value of the stock would shoot up before the time period of the option expires.
In case if the market value does not increase, beyond the prefixed contract price the investor chooses not to exercise the option. Sweat equity of several companies have a default facility of call option, in relation with the company.
✦ The put options on the contract give the holder a right to sell at a prefixed price within a stipulated time period. The put option holder aims to sell at a market value where the prefixed price exceeds the current market value. Sweat equity, initial public offers and other stocks with low market performance can have such an option contract.
In common market practices, buying a call option is more common than buying a put option. It must be noted that stock option are not permitted and are completely banned as per some jurisdictions, and trade of some securities is kept exclusively through the exchange.
Some exchanges on the other hand permit such a trade. In some cases, the option itself, i.e, the contract or the right of the seller can also be brought and sold.