Learn The Stock Market And How to Trade

Most investors, when they have a hunch that the price of a given stock is going to move up or down, will buy or sell short the company’s shares in an effort to benefit from the move that they anticipate. Call or put options allow investors to use leverage and attempt to make a greater percentage gain with a given amount of money than they would by simply buying or shorting shares. Options should be purchased by more sophisticated investors only, because being on the wrong end of a leveraged investment means that you leave yourself open to losing a greater percentage, or all, of the money you have in that position.

But you assume no risk in simply having stock options explained to you. An option is simply the right to buy (in the case of a call option) or sell (for a put option) 100 shares of stock at a given price, at a given date in the future. Here are a few critical things to understand:

You are buying the right to buy the shares, not the shares. The right has a value that will fluctuate between now and the so-called expiration date of the option, based on movements in the share price. You may buy and sell this right before options expiration; most people do not buy options to actually purchase the shares, but to make money from the fluctuations in the value of the option.

Stock options have a strike price that is the amount at which you may purchase the shares, if you hold to expiration. If, at options expiration, the price of the stock is below the strike price (i.e. out of the money) the option will expire worthless, because having the right to buy something at a price that is above the current market price has no value.

If, at options expiration, the price of the stock is above the strike price (i.e. in the money) the option will have an intrinsic value that is determined by how many points the stock price is above the strike price, times 100 (because each contract covers 100 shares of stock).

Maybe the hardest thing conceptually about understanding stock options is the concept of time value. In addition to the intrinsic value, which as we have seen will be zero if the stock price is below the strike price of the contract, the market will ascribe a value to our contract based on how much time is left until expiration, and the likelihood that the option will expire in the money (as determined by the “collective wisdom” of the market). This means that while an options contract may have zero intrinsic value, it can still have value because of the time value component, and the stock’s potential to move higher than the strike price before expiration.

Even the most seasoned investors use only a portion of their investment funds to trade options. The old adage is: buy options only with money that you can truly afford to lose. The good news about options is that you cannot lose more than you invest, but studies have shown that approximately 90% of long put and call options positions either expire worthless or are sold at a loss. That should be your real lesson from this stock options explanation: buyer beware: do your homework and don’t get greedy.

Related posts:

1. Improve Returns By Writing Covered Calls
2. Why Investors May Use Stock Option Trading
3. Stock Symbol
4. The Basics of the Put Option
5. Stock Split