What Is an Equity Derivative?
- A stock option is a contract giving the stock option buyer, or holder, the right, but not the obligation, to buy or sell a specified number of stock shares (usually 100 shares) at a set price by a certain date. The terms of the contract are binding on the seller, or writer, of the contract, and he must buy or sell according to the contract, if the holder exercises the option. There are two types of options--the put and the call. A put is an option to sell at a specified price. A call is an option to buy at a specified price.
- In a stock option contract, the cost of the option the holder pays the seller is called the premium. The specified price of the underlying stock is called the strike price. The market price of the stock must rise above the strike price in a call option or fall below the strike price in a put option before the holder can exercise the option to profit from the option. The movement must take place before the expiration date of the option. The difference between market price and strike price is said to be "in-the-money," higher than the strike price for a call option and lower than the strike price for a put option. The difference between the strike price and the market price of the stock is called the intrinsic value. Hedging is a strategy used to limit loss if a stock loses value. Speculating is betting on the movement of the stock value one way or the other.
- The holder of a put option can limit, or hedge, his loss if he owns the underlying stock and the price drops significantly below the strike price. If the holder is speculating, he doesn't own the underlying stock, but he his betting that the market price will drop significantly below the strike price. Then he can buy the stock on the open market at the lower price, and the writer is obligated to buy it from him at the strike price. The intrinsic value is the holder's profit.
- With a call option, the holder, who doesn't own the underlying stock, is betting that the market price of the stock will soar above the strike price. Then, he can buy the stock from the writer at the strike price, paying a lower price for a high priced stock.
- A speculator is a risk taker. A holder can make a profit on the movement of the market in either direction. He can bet on the market moving down with a put option or on the market moving up with a call option. It's a risky strategy because the speculative holder has to be right on which way the market will move, the size of the movement and the timing of the movement. He also has to take into account the cost of the premium and the commissions on stock purchases and sales to make a profit.
- Stock options, along with other equity derivatives, have a trading value of their own. Holders often close out, or sell their options before the expiration date rather than exercise the options. They can sell to another party or on the open market for a higher price than the premium they paid. Writers will sometimes buy their options back to close. Option trading is a significant part of the securities market, but it is much more complex than buying or selling securities themselves, and it takes a sophisticated investor to understand these complexities.
