Investors in the stock market have a vast arsenal of tools at their disposal. However, many of the tools are geared towards short-term trading opportunities.
Long-term investors in the stock market rarely need most of these tools. On occasion however, some of the tools may prove useful.
Stock options are such a tool. Options allow investors to profit from the rise or fall in price of a particular stock. Many traders use options and the various strategies to good advantage, but options are not for beginners.
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date.
Investors buy and sell options just like stocks. There are two basic types of options:
- The call option
- The put option
The Call Option
The call option is the right to buy the underlying security at a certain price on or before a certain date.
You would buy a call option if you anticipated the price of the underlying security was going to rise before the option reached expiration. For example:
Company XYZ in trading at $25 per share and you believe the stock is headed up. You could buy shares of the stock or you could buy a call option. Say a call option that gives you the right, but not the obligation, to buy 100 shares of XYZ anytime in the next 90 days for $26 per share could be purchased for $100 called the premium. It is calculated by taking the difference between the $25 trading price and the $26 option price ($1) and multiplying by 100.
If you are right and the stock rises to $30 per share before option expires, you could exercise your option and buy 100 shares at $26 per share and sell them for an immediate profit of $3 per share ($30 - $26 = $4 - $1 for the option = $3 per share profit).
You could also simply trade the option for a profit without actually buying the shares of stock.
If you had figured wrong and the stock went nowhere or fell from the original $26 per share to $24 per share, you would simply let the option expire and suffer only a $100 loss (the cost of the option).
The Put Option
The put option is the right to sell the underlying security at a certain price on or before a certain date.
You would buy a put option if you felt the price of a stock was going down before the option reached expiration.
Continuing with out XYZ example, if you felt the stock was about to tank from $25 per share, the only way to profit would be to short the stock, which can be a risky move if you're wrong. See < href="http://stocks.about.com/od/advancedtrading/a/shortsell110804.htm">Short Selling - Not for the Faint Hearted.
You could purchase a put option at $24 per share for $100 (or $1 per share), which would give you the right to sell 100 shares of XYZ at $24 per share.
If the stock drops to $19 per share, you could, in theory buy 100 shares on the open market for $19 per share, then exercise you put option giving you the right to sell the stock at $24 per share - making a $5 per share profit, minus the option cost.
As a practical matter, you would trade your put option, which would now be worth something close to $5 per share or $500.
Basic Option Facts
Here are some quick facts about options:
- Options are quoted in per share prices, but only sold in 100 share lots. For example, a call option might be quoted at $2, but you would pay $200 because options are always sold in 100-share lots.
- The Strike Price (or Exercise Price) is price the underlying security can be bought or sold for as detailed in the option contract. You identify options by the month they expire, whether they are a put or call option, and the strike price. For example, an "XYZ April25 Call" would be a call option on XYZ stock with a strike price of 25 that expires in April.
- The Expiration Date is the month in which the option expires. All options expire on the third Friday of the month unless that Friday is a holiday, then the options expire on Thursday.
This quick overview of options gives you an idea of what they are all about, but it is the very tip of the proverbial iceberg. Options are not for the beginning investor, but do offer advanced traders another tool for their investment arsenal and can be used by long-term investors who are properly schooled in all the complexities. Note: All option quotes in this article are for illustration only. Trading and pricing of options are complicated topics involving many factors not mentioned here.