Options belong to a class of financial instruments called derivative securities. Like most derivatives, options move very violently and are far riskier financial instruments than stocks or bonds. Trading options without understanding the dangers involved can result in financial ruin.
Option Basics Overview
An option gives the holder the right, but not the obligation, to buy or sell a specific quantity of an asset at a predetermined date and price. A call option gives the right to buy, while a put option provides the chance to sell an asset.
A call option on 100 Wal-Mart shares with a strike price of $50, expiring on Dec. 1, allows you to buy 100 shares of Wal-Mart at $50 each on Dec. 1. The $50 is referred to as the strike price. If this were a put option, the holder could sell Wal-Mart at $50 per share, if she so chose, on Dec. 1.
Call Option Volatility
Volatility is a measure how how violently the price of a security can appreciate or deflate. The more volatile an asset, the greater the risks involved. A call option is always more volatile than the stock it allows the holder to purchase.
In the previous example, if the price of Wal-Mart is $51 on Dec. 1, the option is worth $100, because the holder can make $100 by purchasing 100 shares at $50 each and selling them at $51 in the open market. If Wal-Mart climbs to $52, the same option is worth $200. In other words, a less than 2 percent advance in the underlying stock price, as it goes from $51 to $52, results in the doubling of the option's value.
Total Loss for Call Option
Now guess what the same option is worth if Wal-Mart is trading at $50 at the time of expiration. Well the call option would be worth $0, because it provides no valuable privilege to the holder at all. The right to purchase Wal-Mart at $50 a piece is useless because anyone can buy the same stock at the same price in the open market.
If the price of the stock, or any asset that the option is linked to, is equal to or falls below the strike price of the call option, the option is worth $0. In such a case you will lose 100 percent of the money you invested in the call option. If you were to buy even a very speculative stock, however, very rarely would the stock value fall to zero, resulting in the same kind of loss. Even the shares of bankrupt firms are often worth something.
Options Trade Privileges
Due to the excessive risk of both call and put options, your broker must, by law, evaluate your investment expertise before allowing you to buy options. In the options trading application, you will be asked questions about your trading experience, risk tolerance and so on.
For your own sake, do not misrepresent your credentials on this application. Even if you are cleared for options trades, only invest a small sum of money in options, preferably no more than 5 to 10 percent of your portfolio, and act with the full understanding that you may lose the entire sum committed to options trades.
