Options are financial instruments that do just what they say: they give you, as the investor, additional choices other than just buying and selling assets.
The benefits of incorporating options into your investing plans are many, including:
- They provide for a lot of leverage; that is, you can control a lot of assets with a relatively small amount of money.
- They can also provide a means of minimizing risk while creating additional income.
A stock option is a contract that allows an investor the option to purchase or sell 100 shares of stock at a predetermined price before a specific date. Click here to receive alerts with expert advice about which options to buy and when!
These terms are important when looking at options:
- Call option. Gives the buyer of the option the right to purchase the associated stock.
- Put option. Gives the buyer of the option the right to sell the associated stock.
- Premium. This is the cost of the option that the option buyer has to pay to the stockholder for the right of the option.
- Strike price. The agreed upon price that the stock can be bought or sold prior to the expiration date.
- Expiration date. This is the date that the option expires. An expired option has no value and the holder has lost all rights associated with the option.
Call Option Basics
Imagine that a stock is currently selling for $50 and you feel confident that the stock will go up. After checking out the options market, you see that you can purchase options that give you the right to purchase the stock at $53 within in the next 90 days. The cost of the option is $1.50 / share. The options must be purchased in lots of 100 shares.
You decide to purchase 2 lots (200 shares) for a total of $300.
Understand what this means; you would now have the right to purchase 200 shares of the underlying stock for $53 within the next 90 days.
There are only 2 possible scenarios:
- The stock does not rise above $53, in which case the option would simply expire. After all, if the stock price were only $52, why would you pay $53? Keep in mind that the vast majority of stock options are never exercised. This situation is not unusual.
- The stock price rises above $53. You could then purchase the stock at $53 and resell it at the current price. So, if the stock was currently valued at $60, you would make $7/share × 200 shares = $1,400. Remember that you paid $300 for your options, so you really made $1,100 minus any other transactional costs.
You can also choose to sell call options and give someone the right to purchase your shares of stock. This can be a great way to earn some extra income from your investments.
Of course, if your stock goes up considerably, someone else will get most of that gain. But at least you got to collect the option money and still sell at a profit.
Put Option Basics
As we said, a put option gives the option buyer the right to sell his or her stock at a predetermined price by a specific date. The person selling the option must buy that stock if the option is exercised.
Let’s look at another example:
Suppose you own 500 shares of at stock that is currently priced at $40 / share, but you feel confident that the price is going to fall considerably.
You decide to buy put options, and the options market states that put options for your stock are $1 for a strike price of $38 with a 60-day expiration date.
The seller of your options obviously believes that the price is going to stay above $38 for the next 60 days, because he doesn’t want to be forced to buy a stock at $38/share if the market price is lower than that. So he’s willing to take $500 ($1/share × 500 shares) from you.
Again, there are 2 scenarios:
- The price falls below $38. You could then sell your shares for $38. Let’s suppose that the stock price had fallen to $30/share. You would have saved yourself $4,000 worth of loss. ($8/share × 500 shares.) Keep in mind you are out $500 for the option premiums.
- The price stays above $38. You would not exercise your option; it would expire and the other party would simply keep the $500 that you paid for the option.
It’s important to remember that you don’t even need to own the stock in question.
You could still exercise the option by going out in the market, purchasing the shares for $30 and selling them for $38 to the option seller, and make a $3,500 profit ($4,000 – $500). In most cases, the purchaser of the option does not own the stock at that time.
Options can be a great way to control a lot of stock with a little bit of money. A lot of money can be made quickly with options, but options simply expire and are not exercised in most cases.
You now have the basics. We didn’t cover “naked call options,” but those can be rather risky unless you’re extremely careful. Feel free to do some more research in this area if options piqué your interest.
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