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Charles J. Corrado_Fundamentals of Investments - Chapter 14

CHAPTER 14 Stock Options Options have fascinated investors for centuries. The option concept is simple. Instead of buying stock shares today, you buy an option to buy the stock at a later date at a price specified in the option contract. You are not obligated to exercise the option, however, unless doing so benefits you. | CHAPTER 14 Stock Options Options have fascinated investors for centuries. The option concept is simple. Instead of buying stock shares today you buy an option to buy the stock at a later date at a price specified in the option contract. You are not obligated to exercise the option however unless doing so benefits you. Moreover the most you can lose is the original price of the option which is normally only a fraction of the stock price. Sounds good doesn t it Options on common stocks have traded in financial markets for about as long as have common stocks. However it was not until 1973 when the Chicago Board Options Exchange was established that options trading became a large and important part of the financial landscape. Since then the success of options trading has been phenomenal. Much of the success of options trading is attributable to the tremendous flexibility that options offer investors in designing investment strategies. For example options can be used to reduce risk through hedging strategies or to increase risk through speculative strategies. As a result when properly understood and applied options are appealing both to conservative investors and to aggressive speculators. In this chapter we discuss options generally but our primary focus is on options on individual common stocks. However later in the chapter we will also discuss options on stock market indexes which are options on portfolios of common stocks. We begin by reviewing some of the ideas we touched on in Chapter 3 where we very briefly discussed options. 2 Chapter 14 marg. def. derivative security Security whose value is derived from the value of another security. Options are a type of derivative security. marg. def. call option On common stock grants the holder the right but not the obligation to buy the underlying stock at a given strike price. marg. def. put option On common stock grants the holder the right but not the obligation to sell the underlying stock at a given strike price. 14.1