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Trading Stock Options Adds New Dimension

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Trading stock options is not for beginners, but if you do your homework, they can add an extra dimension to your investing.

Options are contracts that give the owner the right, but not the obligation, to buy or sell the underlying security at a fixed price on or before a certain date. For more general information about options, see Options: Understanding the Basics.

What to do with Options?

What can you do with stock options? You have three choices:
  • You can exercise the option and buy or sell the underlying security
  • You can trade options
  • You can use options as a hedge against a loss
This article covers the very basic ways you can use options in your trading.

Exercise the Option

If you own an option to buy or sell a stock, you can exercise that option any time on or before the expiration date.

This allows you to take possession or to sell the stock at the fixed price of the option regardless of the current market price of the stock.

For example, if you believe a stock is going to rise but don’t want to take a chance that it won’t, you could buy a call option near the current market price. If the stock climbed significantly before the expiration of the option, you could exercise the option to buy the stock at the lower price.

You then can hold on to the stock with a built in gain or sell it and pocket the profit, less the cost of the option, commissions and taxes.

The same technique would work with a put option or the right to sell at a fixed price for a stock you though was going to fall in price.

Trade Options

Many investors simply trade options with no intent of ever taking possession of the underlying security.

The pricing of options is extremely complicated, but it boils down to two primary factors:

  • The price of the underlying stock directly affects the price of the option moving it up or down
  • The amount of time remaining on the option affects the price – as time expires the option becomes less desirable
Although supply and demand for an option has some bearing on its price, these two factors are the main drivers.

Investors use a number of different investing strategies to attempt to profit from option trading, although it is considered a high-risk exercise.

Options as a Hedge

You can use options as insurance against losses if you’re nervous about a stock dropping. For example, if you felt a stock might drop, but didn’t want to sell, you could buy a put option at or just below the market price.

The put option would give you the right to sell the stock at that price. If the stock does fall, you can exercise the option and sell at the higher price for a profit or sell the put back to the market at a profit to reduce you cost basis in the stock.

If the stock does not fall, you are out the price of the put (you could sell it for something near the end of its contract period and recover some of your cost.)

Of course, the other way to prevent a loss is to put in a stop-loss order with your broker to sell the stock if it falls below a certain point. See Understanding Stop Loss Orders.

Conclusion

This brief look at options gives you an idea of how powerful they can be as an investment tool. However, you should use caution if you are a beginner – stock options are complicated and you can lose your money quite easily.

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