Trading stock options is not for the faint of heart. While options trading can reward the skillful trader with very high returns, it can also create financial mayhem. Trading options works by using the power of leverage to take advantage of small movements, up or down, in a stock's performance. Before trading options, you should consult with a registered and licensed options broker.
An option gives you the right to buy or sell a particular stock at a predetermined price on or before an expiration date. Call options give you the right to buy a stock, while put options give you the right to sell a stock. The price at which you can buy or sell the stock is called the strike price.
While you have the right to exercise (buy) the stock, you are not obligated to do so. You can always let your options expire, but if you do, you lose any investment made in the actual purchase of the options. Options come in various flavors, each with different strike prices, expiration months and put and call choices.
Call Them Up
Investors who buy call options do so because they feel the price of the underlying stock will go up. If you guessed right, you exercise your option and buy the stock at the lower strike price, then immediately sell the stock in the open market at the higher market price, keeping the difference as your profit.
Put Them Down
Investors who sell put options want the price of the underlying stock to drop, because they already have an option contract giving them the right to sell the stock at a higher price. With put options, if you guess correctly, you immediately buy the stock at the lower market price and sell it at your higher option strike price. The difference becomes your profit.
Prior to the emergence of options trading, if you felt a certain company’s stock was going to increase in value, you had only one way to gain from that increase -- you had to buy the company’s stock. So if you felt Apple Inc. was going to have a short-term gain and you purchased 100 shares at $312.83 each, you made an investment of $31,283 (plus any fees and commissions). If you guessed right and Apple Inc. increased to $340 per share, you made a profit of $2,717 minus any fees and commissions. That’s a gain of roughly 9 percent -- not too shabby.
But suppose you purchased a September 300-call option allowing you to purchase 100 shares of Apple stock at a price (called the premium) of $300 total ($3 premium x 100 shares). If Apple’s stock then went to $340 per share prior to the options expiration date, your call option, which gives you the right to purchase 100 shares of Apple’s stock at $300 per share, now has a value of 40 points and is worth $4,000. That’s because each point over the strike price is worth $100. This means your initial $300 investment increased 1,233.33 percent. The price you pay for the premium is determined by the price of the underlying shares and becomes more valuable as the underlying shares become more valuable.
- "Investment and Speculation with Warrants, Options and Convertibles"; Sidney Fried; 1989
From 2002-2006, Kenneth Hamlett was publisher and head writer for UNSIGNED Music Magazine, an online publication with over 100,000 readers. Prior to establishing UNSIGNED, Hamlett was a business solutions analyst and spent 15 years formulating and writing proposals for supply chain business solutions. He is a graduate of the New York Institute of Photography.