What is a stock option?

A stock option is a financial derivative contract that gives the holder the right, but not the obligation, to buy or sell a specific quantity of a particular stock (or other underlying asset) at an agreed-upon price, known as the strike price, within a specified period of time. Stock options are typically used for various purposes, including speculation, hedging, and as a form of compensation for employees in the form of employee stock options. There are two main types of stock options: call options and put options.

1. Call Option: A call option provides the holder with the right to buy a specific number of shares of the underlying stock at the strike price before a predetermined expiration date. Call options are used when the investor expects the price of the underlying stock to rise. If the stock price increases above the strike price, the call option can be profitable when exercised. However, the holder is not obligated to exercise the option and can let it expire if it's not profitable.

2. Put Option: A put option, on the other hand, gives the holder the right to sell a specific number of shares of the underlying stock at the strike price before a predetermined expiration date. Put options are used when the investor anticipates that the price of the underlying stock will decrease. If the stock price falls below the strike price, the put option can be profitable when exercised. Like call options, the holder of a put option is not obligated to exercise it.

Key features and terminology associated with stock options include:

• Strike Price: The price at which the underlying asset can be bought (in the case of a call option) or sold (in the case of a put option) when the option is exercised.

• Expiration Date: The date at which the option contract expires, after which the option can no longer be exercised.

• Premium: The price that the option holder pays to the option seller (also known as the writer) to acquire the option. This represents the cost of the option.

• In-the-Money (ITM): An option is considered "in the money" if it would be profitable to exercise it at the current market price of the underlying asset. For call options, this means the market price is above the strike price. For put options, this means the market price is below the strike price.

• Out-of-the-Money (OTM): An option is "out of the money" when it would not be profitable to exercise it at the current market price of the underlying asset. For call options, this means the market price is below the strike price. For put options, this means the market price is above the strike price.

• At-the-Money (ATM): An option is "at the money" when the market price of the underlying asset is approximately equal to the strike price.

• American Option vs. European Option: American options can be exercised at any time before or on the expiration date, while European options can only be exercised on the expiration date itself.

Stock options can be used for various strategies, including speculation on price movements, hedging against adverse price movements, and managing risk. They are commonly traded on options exchanges, and investors should be aware of the risks and complexities associated with options trading before participating in this market.