Equity options, sometimes referred to as stock options, provide investors with a means of participating in a particularly stock's capital appreciation without actually purchasing the stock. Options may also be used to increase an investor's cash flow, to protect gains in stock prices or to prevent losses during a perceived down market. Trading stock options is easy to do. Making money trading stock options is a bit trickier.
Research the different types of options to make sure you understand how they work. There are only two basic types of options, puts and calls, although some sophisticated trading strategies may use various combinations of the two in different configurations. Call options give you the right to purchase the underlying stock at a set price, called the strike price, for a specified amount of time. Put options give you the right to sell the underlying stock at a set price for a specified amount of time. Once that time period ends, called the expiration date, the stock option becomes worthless and ceases to exist.
Determine your purpose for trading stock options. Different investment goals will require different trading strategies and may employ different types of stock options. If you want to generate additional income from stock that you already own you can sell a call option against that stock. If you want to protect gains or prevent losses on a stock you own you can buy a put option. If you believe the price of a particular stock is going to rise, you can participate in the price increase, without buying the stock, by purchasing a call option. The price of the call option will typically rise as the price of the underlying stock rises. You then have the right to exercise the option and purchase the stock at the strike price, or you can sell the option at the increased price and pocket the difference.
Open an account with an investment brokerage firm. Stock options typically trade on major exchanges such as the Chicago Board Options Exchange. You will need a broker to effect your options trades. There are three basic types of brokerage firms. The type you choose to do business with depends on your confidence in your ability to make investment decisions. If you don't feel qualified to make sound investment decisions you will want to rely on the services of a full-service firm. They will charge more for each transaction, but you will have the benefit of their counsel and expertise. Discount brokerage firms offer less in the way of service, but are still available if you need to ask a question. Online brokerage firms provide a means of executing orders, and they provide lots of tools, but you will have to do the research yourself.
Place your order through your broker. Just as with stock orders, you can specify whether you want your order to be placed at the market, which means it will execute at whatever the prevailing price is at the time, or at a set price, in which case the order will only execute if another investor is willing to meet your price.
Watch your options and be ready to trade out of your position or exercise your options if the situation demands it. A stock option has no value in and of itself. It's value is derived from the time remaining prior to expiration and the relationship between the strike price and the actual price of the underlying stock. If the option reaches its expiration date without being exercised it becomes worthless, so you must sell or exercise your stock options prior to that date, or you will lose your entire investment.
- Trading stock options is a riskier investment strategy than owning stocks. Investors may lose some or all of their investment.
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