Understanding Equity Transactions: Stock Contracts II
Written by Bennet Grill for Gaebler Ventures
This second article on stock contracts provides a more detailed explanation of investment strategies with option contracts.
Our first article on stock contracts provided a basic explanation of calls, puts, "going long," and "going short."
In this second and final article in our series on stock contracts, we offer a further explication of the concepts we covered in the first article.
From the two different forms of options contracts--calls and puts, and the two investing strategies going long and going short, there are four resulting options contracts:
A long call is the most basic type of options contract in which an investor is granted the option to purchase a stock at a specified strike price. An investor hopes the price of the stock will increase by a greater amount than the premium he paid for the option so he will be able to sell the shares for a profit.
A long put is an options contract in which an investor is granted the option to sell a stock at a specified strike price. An investor uses a long put with the hope that the price of the stock will fall by more than the amount of the premium that he purchased it for.
In both "long" calls and puts, the investor purchases the option to buy or sell a stock at a specified price and is not obligated or forced to exercise this option. In "short" calls and puts an investor sells the option buy or sell the stock to another investor. The investor who sells the "short" put or call is responsible and obligated to purchase the stock (from the client who has purchased the put) or sell the stock (to the client who has purchased the call) at the specified strike before the option expires.
With a short call, an investor sells the option to purchase stock at a specified strike price. This investor is then required to sell the stock to whoever purchased the call option should they choose to exercise their contract.
Using this strategy an investor hopes that the value of the stock will decrease so he can keep the premium he gained by selling the option--no one will redeem an option to buy if the strike price is higher than the current market price. However, the price of a stock could increase. An investor using a short call is at a risk because he could be forced to sell a stock at a significantly lower price than the current value of the stock.
A short put is a financial instrument in which an investor sells the option to sell stock at a specified strike price. Like a short call, an investor is obligated to conduct a transaction should the owner of the option choose to exercise the contract. An investor who uses a short put must purchase stock from the holder of the option who is choosing to sell the stock at the strike price.
A short put is an investment strategy if one expects the value of the stock to increase--the investor wants to keep the premium of the option and not have the value of the stock decrease lower than the strike price. If the stock does decrease in value, however, the investor will be forced to purchase stock from the holder of the option at a price higher than the market value--causing a loss.
Bennet Grill is a writer who has a passion for business and finance. He is currently an Economics major at Duke University in North Carolina.
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