There are many different types of investment securities or vehicles available to the hopeful investor. The two most-common investment vehicles are Treasurys, such as T-bills or Treasury bonds, and stocks offered by publicly traded companies. A distinguishing feature of Treasurys is that they offer a guaranteed return on investment in the form of a promised interest rate while stocks themselves offer absolutely no guarantee as to ROI. Investors in stocks, though, can make use of various strategies to hedge or lessen their risk of loss, including stock options trading.
In essence, a stock option gives you the right, but no obligation, to purchase or sell a security at an agreed-upon price within a certain time frame. Call options give to their buyers rights to purchase a set number of shares of stock or other securities, called underlying assets, at a preset price, which is more commonly known as its strike price. Purchase of a call option from the trader writing that contract gives you up until the contract’s expiry or expiration date to exercise your purchase of the contract’s underlying assets. Obtaining a low strike price on any options contract will help increase your profit should you decide to exercise your rights under the contract.
Call option and put option contracts are big business on the securities markets. Put options give their buyers rights to sell the underlying assets in those contracts at previously agreed-upon strike prices. Put options are the opposite of call options, because in a put the purchaser believes the sale price of the securities in the contract will be greater than their purchase price by the time the contract’s expiry rolls around. When you decide not to exercise your call or put option contract rights you lose all rights as well as any obligations to buy or sell the shares in that contract. However, traders not exercising rights in call options or put options really only lose the money they paid for those rights, which is usually less than the collective worth of the securities making up those contracts.
Call options in stock options trading give a right to purchase a security at a price you expect to be lower than what the price would be at the contract’s expiration date. Generally, call and put options come bundled in 100-share blocks. To use an example, a 100-share call option might be available from a trader or contract writer at $50, with the premium or fee for each share in the contract being .50 (.50×100 = $50), thus giving the purchaser the right to buy each share at its strike price before the contract expires.
For example, let’s say you purchase a 100-share call option for $50, giving you the right to purchase each share for $10 and the stock’s price rises to $15 by contract expiration date. You now have the right to exercise your purchase option for $1,000 ($10×100 = $1,000) and can quickly sell your 100 shares for $1,500 ($15x$1,000), or a $500 or 50% profit. Before undertaking any sort of stock options trading, you need to know how to intelligently exercise your call or put option rights. All a call or put option contract is, at heart, is a variation of the “buy low, sell high” strategy inherent in all stock investing.
Trading in stock options is more complicated than simply buying a stock at one price and subsequently selling it at a higher price. A major benefit to stock options trading, though, is that it can limit your “downside” or potential loss while increasing your upside potential or profit. After all, you’re under no obligation to buy or sell the securities contained within a stock option contract. All you might lose in a call or put option contract is the premium you pay to the option writer to gain a right to buy or sell those shares.
One mistake rookie options traders make sometime is taking too many risks before they understand the ins-and-outs of the stock options trading world. New options traders should take sufficient time to familiarize themselves with what “naked” or uncovered options are, for instance, because getting caught holding too many of them can quickly lead to financial ruin. Naked or uncovered options create naked positions for traders and they occur when those traders write option contracts without actually owning any of the stock or security being bought or sold.
Writing an option contract giving a purchaser the right to buy or sell stock you don’t really own in that contract is risky business, though it can be lucrative. Most brokerage houses, though, don’t allow new or inexperienced investors to place naked or uncovered option contract orders. New investors entering the stock options trading world should take small, easily handled steps such as basic call or put option contracts, which can also be highly profitable, before they dive into the deep end of the options pool, so to speak. In reality, before you even engage in the business of trading in stock options you should first spend time learning from far more experienced traders willing to share the ins-and-out of stock options.
Before you even think about taking out a stock option make sure you stop by Option Millionaires at stock options trading for the best in options trading advice and training.