Explaining stock options basics to new investors poses something of a challenge. The tricky thing with options is that you are not buying and selling shares of company stock; instead one buys the right to buy, in the case of calls, or sell in the case of puts, 100 shares of a company’s stock by a certain date in the future.
Looking at the reasons why an investor would want to do this can help us to understand options in the first place. It really comes down to a financial concept called leverage. When you buy 100 shares of stock at $50 per share you will have to come up with $5000 (we’ll ignore the possibility of your broker extending you margin to purchase the shares). This is a non-leveraged investment. If you buy a house for $200,000 and put $40,000 down, you are in effect engaging in a rather highly leveraged financial transaction, as you are controlling an asset with funds equal to only a small fraction of its full value.
With options you do not borrow money from anyone to control the 100 shares of stock that one option contract covers. The investment is simply structured so that you can choose the amount of leverage that you employ it, and here’s how you do it:
If you would like to use just a little bit of money and get into a highly leveraged position you can buy an option that allows you to purchase shares at a price that is quite a bit higher than the current stock price, at a the date that is fairly near in the future. The idea is that the less likely it is for the stock to get that so-called strike price before the option expires, the less money you pay to purchase the option. If the stock price does rise dramatically before the option expires, you will see a rapid rise in the value of your option, and if it goes above the strike price you can (probably) expect to see a handsome return. In all likelihood it will be multiples of your original investment.
Options can also be used for less leveraged plays. Perhaps you buy an option that gives you the right to purchase shares near where the stock is currently trading. If the stock rises as you hope you will see an increase in the value of your option, all else being equal, but since you will pay more for the initial initial purchase of the option (because the prospect of the stock price rising above the strike price is more likely) your percentage gain most likely won’t be as high as in the first example, assuming again that you get the move that you expect.
I’ve tried to illustrate some of the complexity involved in trading stock options, but this is just the tip of the iceberg. As you learn about options please do yourself a favor and paper trade for months, possible with some high-quality stock option trading software, to get a feel for how difficult is to make money consistently with options, before committing any actual funds.
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