Common Questions about Stock Options and Derivatives

Options and derivatives are easily the most complex of the various investment related subject matter.   Even those who do understand them, often find themselves perplexed by the more advanced features of some of these esoteric financial instruments.   Those who don't understand them often claim that they are merely speculative instruments and are somewhat akin to gambling.   However, this is not true at all.   An option instrument and other similar derivatives can serve an important purpose in any investment plan.  Believe it or not, using them often gives protection against risk rather than adding to it.  The following series of articles will explore the investment uses for derivatives and how they can be integrated as a part of any investment plan.  Before we go more in depth with the articles, you can review the following responses to common questions about these esoteric investments.

Are options available on any stock traded on the NYSE or OTC (Nasdaq) market?
No.  Just like anything else, what stocks are available in the options market depends on demand.  Thus, options are typically available on the more well know and highly traded stocks but not on those which are obscure or have light trading volumes.

Most options strategies revolve around profiting on major swings in a stocks price?
No. In fact options are a bit more versatile than most believe.  They can be used to generate income or to protect the value of a portfolio just as easily as they can be used to generate profits on the price fluctuation of the underlying stock.

Options have no place in the portfolio of the conservative investor?
This may seem to be the case and many conservative investors will certainly believe it to be so, but the truth is options can provide added security and portfolio diversification in almost any portfolio.  Thus, it is possible for a conservative investor to employ them as part of a strategy for wealth preservation as opposed to speculative trading.

Why do they call them "options"?
Because an option is exactly what they are.  They give the buyer an option to buy or sell an underlying security at a specific price, at a specific time.  See the more in depth article for an explanation of how this works.

Is the buyer compelled to do anything when he purchases an option?
NO.  This is important to understand.  The buyer of an option is not required to do anything with that option.  He is always able to let it expire by taking no action.  Therefore, those who fear they will be required to buy the underlying shares of a call option can rest assured that there is no obligation to do so.

What does it mean to "exercise" an option?
When an option is "exercised" then the underlying transaction takes place at the specified price set out by the option contract.  Thus, the owner of a call option would buy the underlying shares at the price set out in the contract.  By the same token, the owner of a put option would sell the shares at the underlying price.

Can the buyer of an option exercise it anytime he wants?
This depends on the type of option it involves.  There are two forms of options on the market.  There are American style options, which allow an individual to exercise the option anytime up until the expiration date, and there are European style options, which only allow the owner to exercise the option on the date of expiration.

How do Index Options differ from other options?
Index options trade on the aggregate price of an entire stock index.  As a result there are special rules and considerations, which must be understood before investing in these types of financial instruments.  See the more in depth article for details on Index Options.

When is a put option "in the money"?
Put options are considered to be "in the money" when the share price is below the exercise price.

When is a call option "in the money"?
Call options are considered to be "in the money" when the share price is above the exercise price. 
