An option is a contract between a buyer and a seller on a securities. So stock option is a contract for a stock. There are two basic types of options, the American and European. Most exchange-traded options is an American option which is a contract that can be exercised at any time between the date of purchase and the expiration date. The other type of option is an European option. It is an option contract that can only be exercised on the expiration date.
There are two terms you need to know in option. The price at which an underlying stock can be purchased or sold is called strike price. Expiration date is when the option will expire where you need to execute the option or leave it worthless.
There are basically two reasons why people use stock option. The first is for speculation. Here people try to “guess” the direction of a stock’s movement, the magnitude and the timing of this movement. You will win money if your guess is right and lose money if you are wrong.
The second reason is for hedging or an insurance for stock. If you buy a stock, and are afraid that the stock will go down, then you can insure it using option. When the stock drop, you will gain from option. So by using options, you can limit your loss.
There are two basic option strategy, the Calls and Puts. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset. When you believe that a stock if going to be up next year, buy call option. But if you believe the price will go down next year, buy call option.
From this basic strategy, you can combine it to create a more complex strategy. For example you can buy two call option with different expiration date and price, and two put with different expiration date and price.
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