Stock option

There are two main types of stock options:

  • A call stock option will give the holder a right, but not an obligation, to purchase the underlying share for a specified price, during a specific period of time.
  • A put stock option will give the holder a right, but not an obligation, to sell the underlying share for a specified price, during a specific period of time.

optionThe individual or entity that creates a stock option is called the writer. It is the writer that has a duty to honor the stock option if the holder of the stock option decides to exercise it.

When you purchase a stock option, the purchase price is called premium. The price that you pay for the underlying share if you elect to exercise your stock option is called strike price.

The term sheet includes important information about the stock option, including information about the settlement terms. For instance, is the writer of the call stock option actually obligated to provide you with a share in the company? Or is it permissible for the writer to simply settle in cash instead by paying your the difference between the strike price and the market price on the exercise day?

The stock option is far from the only type of option available on the financial instruments market. You can for instance trade in bond options, commodity options, and equity options. What they all have in common is that they give the holder a right, but not an obligation.

Trading in stock options

Only a fraction of all stock options are listed on any exchange. Instead, they are traded over-the-counter (OTC).

Even though it will limit the list of available stock options, sticking to exchange listed stock options does come with certain advantages.

  • Trading in stock options that are listed on a reputable exchange will provide an extra layer of security, since exchanges set and enforce rules in order to protect investors.
  • Stock options that are traded on an exchange are highly standardized contracts. If you engage in OTC trading, you have to be much more vigilant when going through the stock option contract (term sheet) since there is no mandatory standardization.
  • Stock options listed at an exchange are typically (but not always) settled through a clearinghouse that will partly or wholly assume responsibility for honoring the stock option if the writer is unwilling or unable to do so. There are also exchanges that will assume this responsibility themselves.

binary optionWhen can I exercise my stock option?

If you elect to use your stock option to buy (call option) or sell (put option) the underlying share, this is referred to as exercising the option.

When you can exercise the option will be determined by the term sheet. A majority of all stock options are either European-style or American-style, but more exotic stock options do exist so it is important to find out this information before you purchase any stock option.

  • A European-style stock option can only be exercised on the expiration date.
  • An American-style stock option can be exercised on any day until it expires. The premium for this type of stock option is usually a bit higher than the premium for a European-style stock option, since American-style gives the holder of the option more flexibility.
  • A Bermuda-style stock option can only be exercised on specific dates outlined in the term sheet, e.g. only on the 15th of January, April, July and October 2018.