Investing In Stock Options

Stock options are a financial instrument that gives the option holder the right to purchase or sell the underlying stock at a set straight strike price when the option is exercised. However, is not necessary to actually exercise the option in order to receive in nominal financial return on an options trade which makes them more appealing to individual investors.

Call Options

A call option provides the option holder the right to buy the underlying stock at the strike price specified in the option. Often call options are purchased with the expectation that the underlying stock will increase in value prior to the expiration date. For example, an option can be purchased for Company XYZ that will allow the option holder to purchase 100 shares at $50.00 per share prior to the expiration date. If company XYZ releases a positive earnings report and the stock goes up then an option holder could exercise the call option to then purchase 100 shares at $50.00 per share and then immediately sell those same shares at the current market price for significant return. The option holder can also choose to sell the option if they don't have the capital to purchase the shares of underlying stock and still make a significant percentage return from the option having gone up in value.

Put Options

A put option gives the option holder the right to sell a stock at a specified strike price before the expiration date. This type of option is essentially shorting the stock in the expectation the underlying stock will decrease in value. For example, if company ABC has a poor earnings report and the stock and decreases from $50.00 per share to $30.00 per share, a put option holder could choose to exercise the option which would allow them too purchase shares at the current market value of $30.00 to share and sell them at $50.00 per share. The option holder could also choose not to exercise the option but instead trade the option back into the options market and realize a gain in the options value.

Hedging

Why would someone trade in options if they lose their value? Options are often used as a hedge against other financial securities. For a small monetary value, options can be purchased with an equivalent value of the investor owned stock to offset potential losses. If an investor owns 1000 shares of $300 stock but needs the money in a few months or doesn't want to worry about losing the principle they can purchase 10 put options of that same stock as a hedge. Hedging is a way to protect an underlying investment with an offsetting investment purchase.

Time Sensitive

One key consideration to trading options is understanding they are time sensitive investments. That means that after the term of the option, which is when it has passed the expiration date, the option ceases to have any intrinsic value. Time sensitivity is important because unlike stocks and bonds which can be held in a portfolio for years to hopefully recoup losses, options do not have that luxury and therefore should be traded cautiously.

Trading Options

Many brokerage houses allow investors to trade in options but often require investors to be at a certain level of investment sophistication. Because options essentially work as margins against an underlying stock, if the options trader writes a covered call and doesn't have the money or underlying stock to execute the option than there would be significant financial repercussions.

Options trading is not for all investors but when used as a hedge against an existing stock portfolio or traded without the need to provide the underlying stock then options are a valuable financial tool which more sophisticated investors should consider.