You are on page 1of 5

Running Head: Stock Options

Ugonma Nwogu
FINC 510 Foundations of Financial Management
Davenport University
Professor Kevin Bauer
Stock Options
06/27/14

Stocks Options

Stock Options
An option is said to be a contractual agreement that allows the owners of that
option to purchase or sell their asset at a price, which was predetermined during a
particular time frame. In the investment world, there are a variety of options and option
markets available; they include the call option, put option, American option, and
European option. There are also advantages and disadvantages associated with stock
options, which will later be discussed in this paper.
Call option, is an option that qualifies the owner to purchase, particularly at a
fixed price, a share of stock that is known as the strike price (this can also be known as
the exercise price, which is the price you can rightly exercise an option). On the other
hand, a Put Option affords the owners to sell any share of stock they own, but it has to be
at a fixed strike price for the transaction to occur. For every option, there is an expiration
date attached to it, meaning that after the expiration date the option cannot be used.
However, there are exceptions to the rule, the American Option is a stock preference that
can be used at any time prior to the expiration date. Alternatively, an option that only
allows the owner to use it on its expiration date is called the European option. ). Both
American- and European-style call and put options share the following standard
characteristics: both have a set strike price, both have a set expiration date, both use
similar structures for their ticker symbols, both are traded on exchanges (Investor Place,
2008).
According to Ehrhardt and Brigham, an options price always will be greater
than (or equal to) its exercise value. If the options price were less, you could buy the
option and immediately exercise it, reaping a sure gain (Pg. 307). The time value is the

Stocks Options

difference concerning an options price and the exercise value; it is virtually the extra
amount of money above the options exercise price the investor purchasing the stock is
willing to pay for the opportunity to have the stock appreciate over time (Ehrhardt and
Brigham, 2004).
Options have been known to be traded on various stock exchanges, the Chicago
Board Options Exchange, also known as the CBOE, is the most prominent and oldest
exchange known. Investors can successfully trade their current options in a secondary
market, just like other stocks are traded in secondary markets (Ehrhardt and Brigham,
2004). Writing an option is defined as an investor issuing a new option, again, almost
reflective of how corporations issue shares of stock to the public. For example, you
could write a call option and sell it to some other investor. You would receive cash from
the option buyer at the time you wrote the option, but you would be obligated to sell a
share of stock at the strike price if the option buyer later decided to exercise the option
(Pg. 308). Therefore, the stock option has two different participating parties; they include
the buyer and the writer, with the Chicago Board Options Exchange playing the role of an
arbitrator in the transactions. The investors who write call options that are held against
their portfolio are known to be selling what is called a covered option. On the other hand,
a naked option is sold with the exclusion of a stock backing it up.
There are benefits to trading options; they are accessible on numerous other
exchange platforms, for example, the NYSE Index and the S&P 100 Index. These index
options allow investors to hedge (in other words, bet) on the increase or decline in the
general market and individual stocks. Another benefit is the leverage involved in option
trading makes it possible for speculators with just a few dollars to make a fortune almost

Stocks Options

overnight (Pg. 309). Investors who have a decent size portfolio have the opportunity to
sell their options against the stocks and profit the price of the option because there is a
reduced brokerage commission involved; this is regardless if the stock price stays
constant or not. The greatest benefit of options is that they can be used successfully to
protect the value of a single stock or portfolio, once a hedge has been created. The hedge
will act as an inexpensive insurance to help investors avoid detrimental risks against their
portfolio if the market happens to change negatively. Jim Graham reports that stock
options provide investors with the great opportunity to leverage their investment capital,
give you greater flexibility when making investment decisions, and allow you to tailor
your risk to fit your personal comfort level (Discover Options, 2014).
The disadvantage of options trading may cause investors to think twice about it at
some point. First, the cost of trading such option, including the commissions and ask
spread, are considerably more than trading regular stock. Consequently, the costs alone
will inevitable decrease the profits. Secondly, options are time sensitive naturally;
therefore, many options have an expiration date that will render them worthless. The time
decay of the option begins in the last 30 days of its life; it will be more profitable for the
investor to be on the selling side of the contract than the buying end.
In conclusion, call trading options are profitable if one understands how and what
to do with them in order to make them work for you. It will be wise for any one who is
aspiring to be a trader to become knowledgeable with the advantages and disadvantages
of call trading options. This also included becoming acquainted with strategies that are
put in place to minimize the risk and maximize the profit.

Stocks Options

5
References:

Ehrhardt, Michael C., and Eugene F. Brigham. Corporate finance: a focused approach.
Mason, Ohio: Thomson/South-Western, 2004. Print.
Graham, J. (n.d.). The Benefits of Trading with Options. The Benefits of Trading with
Options. Retrieved June 28, 2014, from
https://discoveroptions.com/mixed/content/education/articles/benefitsofoptions.ht
ml
Hansen, W. (2008, November 8). Options Trading - American vs. European |
InvestorPlace.InvestorPlace RSS. Retrieved June 28, 2014, from
http://investorplace.com/2008/11/option-styles-american-vseuropean/#.U69tSY1dUcs
Wreford, T. (n.d.). What is Option Trading. Zero Million . Retrieved June 27, 2014, from
http://www.zeromillion.com/financial-services/options-trading-advantages-anddisadvantages-by-tim-wreford.html