Although most investors understand what buying a stock is, far fewer understand the world of trading stock options. Often labeled highly volatile and risky, there are ways to benefit from the trading stock options in lieu of trading the actual stock.
Stock options do not initially involve the actual stock of publicly traded companies. Instead, options are contracts to buy or sell a stock sometime in the future. That means when you buy or sell a stock option, at that exact moment you are not actually trading stock, but promising to do so at some point in the future.
An option is a contract an investor can buy or sell, and depending on what option the investor transacts, he has either acquired the right to do something or the obligation. Specifically, having the right means you can exercise an action if you want, while having an obligation means you are required to.
Investors buy options because one gets more bang for the buck, which means they can be twice as lucrative or twice as dangerous. Simply put, options is stock trading on steroids.
Without getting too technical, the easiest way to learn the world of options is to learn how to buy them. One can sell an option, but because of the many different types of contract conditions that exist, buying an option is the easiest to understand.
There are two types of stock options: a “call” and a “put.” You could sell or buy a call option, or sell or buy a put option. In the example below, we are buying a call option because that is the simplest transaction to start one’s education.
Without getting too deep into how they are priced, as options price rather oddly, we are just going to buy a call option on a fictional company I am calling the ACME ANVIL COMPANY (AAC).
Example: AAC price is 100 per share. You think the price of AAC will rise for whatever reason. You don’t have enough money, or perhaps don’t want to spend a lot of money, to profit from the move, so you decide to try and benefit from buying an option contract called a call.
Doing so means you will spend a lot less to participate in an AAC move. You could buy the stock at $100 share, meaning 100 shares will cost you will cost you $10,000, or you could buy a call option, which controls the same 100 shares, meaning you will still get the same benefit (profit) of a 100 share move, but you will be likely spending a lot less to participate. Remember options are highly leveraged.
You first find if an option is available on AAC and we will pick a call contract with a price of $105. You decide the stock should move quickly so you buy a contract that expires in one month.
Since option contracts have a “strike” price and a “maturity” date, and many strikes and dates can be offered, you can pick what price and date you prefer and each one probably has a different price. Our fictional contract is the $105 strike and is one month out, say Sept. 15.
You will now pay for the contract. Assuming you pay an arbitrary price of $500 for one call option (remember prices, maturity dates and strike prices vary and you pick which one you want), you now own one call contract, which controls 100 shares of AAC, and you paid $500 for it.
In a nutshell, if AAC goes above 105 by Sept. 15, you make money. If it goes way past 105, you make more money. The higher it goes by Sept. 15, the more money you make.
If AAC never gets to 105 by Sept. 15, you lose all of your money. Although trading professionals will notice the explanation above leaves out a ton of details and may not reflect actual gains or losses, the general concept of how this option works is conveyed in broad detail only. If the price goes above the contracts strike price by the maturity date, it can mean profits to the investor.
In conclusion, there is a lot more to options than explained above, but the general concept is options can give you extreme leverage, which means more bang for your buck and a cheap way to play a stock, can amplify losses or gains and with astounding speed, and have time factor which can work for or against the investor depending on the option strategy selected.
Marc Cuniberti holds a B.A in Economics with honors from San Diego State University and is the host of Money Matters carried on 66 stations nationwide. California Insurance LIc# 0L34249. Call him at 530-559-1214 or visit http://www.moneymanagementradio.com