20 Investments: Options (Stocks)
What Is It?
Options are a privilege sold by one party to another that offers the buyer the right to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time or on a specific date.
There are two basic types of options: calls and puts.
A call gives the holder the right to buy an asset (usually stocks) at a certain price within a specific period of time. Buyers of calls hope that the stock will increase substantially before the option expires, so they can then buy and quickly resell the amount of stock specified in the contract, or merely be paid the difference in the stock price when they go to exercise the option.
A put gives the holder the right to sell an asset (usually stocks) at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts are betting that the price of the stock will fall before the option expires, thus enabling them to sell it at a price higher than its current market value and reap an instant profit.
The exercise or strike price of the option is what the stock price must pass (for calls) or go below (for puts) before options can be exercised for a profit. All of this must occur before the maturity date, also known as the expiration date. It should be noted that an option gives the holder the right, not the obligation, to do something. The holder is not required to exercise if he/she does not want to or if the terms are not favorable.
Objectives and Risks
For most options strategies, you need to have a very high risk tolerance; it is not uncommon for a stock option to fluctuate 30-40% or more in a single trading day.
The objectives of options are up to the holder. There are two types of people who use options: speculators and hedgers. Speculators simply buy an option because they think the stock will go either up or down over the next little while. Hedgers use options strategies - for example, the covered call, which allows them to reduce their risk and essentially lock-in the current market price of a security. Options (and futures) are popular with institutional investors because they allow institutions to control the amount of risk they are exposed to.
How To Buy or Sell It
Options trade very similarly to stocks and can be purchased through just about any discount or full-service broker. To trade options, you need to be approved by the brokerage first. They will typically ask questions to determine if you have enough knowledge or experience before they will approve you. Options are usually bought through a margin account, or borrowed money. (For a more in-depth look at options, see our Options Basics Tutorial.)
Allow you to drastically increase your leverage in a stock if you are speculating.
Options in 100 shares will cost much less than actually buying the 100 shares.
If used properly, options can be a useful tool in hedging against an existing position. |
Options are highly complex and highly leveraged. If you are using options to speculate, you need to keep a close watch on them and to have a high tolerance for risk.
Options require more than just a basic knowledge of the stock market.
You have the potential to lose a lot of money if you take various positions - for e.g. if you are the writer of an option. |
20 Investments: Preferred Stock
|Two Main Uses
Increase Leverage |