By derivative product we mean that it is a product whose value
is based upon or derived from the price of something else. Since
we are talking about stock options, a stock options
upon, among other things, the price of the underlying stock.
There are also options on other traded securities such as currencies,
indexes and interest rates, but here we will limit our discussion
to stock options, or options based on stocks.
A distinguishing factor of stock options is that is a depreciating
asset in the sense that it has a limited life, and has to be
used before the date on which it expires. As time goes by, the
stock options lose value as it moves closer to its expiration
When we speak of stock options in terms of volume, we refer
to contracts. All stock options contracts are equivalent to
100 shares of stock. When we talk about two contracts, we are
talking about 200 shares, 10 contracts; we are talking about
1,000 shares, 75 contracts 7500 shares and so on.
It is important to understand the dollar cost of stock options
before actually trading them. When stock options are quoted
at $1.00 per contract, the investor must realize that the $1.00
represents a price of $1.00 per share, not per contract. Remember
that each contract is worth 100 shares. This means that if you
were to buy one stock options contract at a quoted price of
$1.00, your total cost will be $100.00 (1 contract x $1.00 per
share x 100 shares per contract). If you were to buy 10 contracts
for $1.50 per contract, your total cost will be $1500.00. Use
the formula below when calculating total dollar cost of the
Total Dollar Cost of Trade = Number of Contracts x Price per
Contract x 100
A stock options contract is literally a sales agreement between
two parties. The two parties are the buyer (or holder) and the
seller (or writer). When you buy a stock options contract you
are considered to be long the stock options. When you sell a
stock options contract, you are considered to be short the stock
. This, of course, is assuming you had no previous position
in the said option.
In a stock options contract, although it seems as though the
buyer and seller must be tied together, they are not. You see,
the buyer doesnt really buy from the seller and the seller
doesnt really sell to the buyer.
In reality, an organization called the OCC or Options Clearing
Corporation steps in between the two sides. The OCC buys from
the seller and sells to the buyer. This makes the OCC neutral,
and it allows both the buyer and the seller to trade out of
a position without involving the other party.