Equity options are contracts based on the exchange of securities at a specified price. Call options give the buyer the right to purchase a security at a stated strike price, while put options allow the buyer to sell an instrument at a strike price. Investors can use their equity as collateral for loans or as a derivative traded on the open market.
To understand equity options, one must first have some understanding of equity. Equity is the value of an asset after deducting the funds owed to purchase the asset. The equity of an investor’s stock portfolio is based on the value of the shares he owns minus any capital borrowed to purchase those shares. When it comes to real estate, an owner can determine the net worth of his property by deducting the balance of his mortgage from the estimated value of the property. Investors can use the value of their equity as collateral for loans, or as a derivative that can be traded on the open market.
Stock options are contracts negotiated between a seller, an option writer, and a buyer or holder of an option, based on the exchange of securities at a specified price, or strike price. There are two types of equity options: call options and put options. Call options give the buyer the right to continue to purchase a security at any given time based on a stated strike price. Those who buy call options expect the value of the security to increase by the time they make their purchase. When a contract is reached for a purchase option, the buyer can choose to continue with the purchase at the specified time or opt out, but the seller is obligated to fulfill the transaction regardless.
Put options are contracts between the owners of an instrument, or a put writer, and an investor, or a put holder who believes that the value of that instrument will fall over a period of time known as the exercise period. The put option holder pays the strike price plus a security premium for one security. If during the exercise period the value of that security falls, he or she can sell the equity option to the sale writer for the original exercise price.
The sales writer hopes that the value of his asset will increase in order for him to benefit from the premium on the sale. The holder of a put option wants the value of that asset to fall below the strike price value so that he can force the writer to buy back the equity option at the strike price. Speculators often use this practice and the risk level is quite high. Most often, stock options are put options in which the owner of a security expects to generate quick income from the price of the premium charged for the sale of the put option.
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