Investing In Stock Options

An option conveys the legal right to buy or sell an underlying entity at a predetermined price by a certain time in the future for a set price. For stocks, an option generally covers 100 shares of the underlying stock. For futures, an option generally covers a single underlying futures contract.

The delivery date, place and type of delivery are clearly defined by the exchange. The purchaser determines the number of options to be purchased and the type of option (call or put). Options are very liquid and the ownership can be transferred easily and quickly.

One of the greatest benefits of investing in stock options, is the trader knows in advance exactly what the financial risk will be; it is the cost of the option (or premium) and the transaction costs (brokerage fees and commissions). The reward depends on how much value the underlying entities gain before the expiration date, and for calls, the potential profit is theoretically unlimited.

For example, a trader could purchase an option for $300 and sell it two weeks later for $3,000 or more. However, most options expire worthless, so the average investor would buy an option for $300 and would lose the $300. The key to successful option trading is to close your position before it expires completely worthless.

How can options be used?

1. Options can manage risk: Options can be thought of as an inexpensive insurance policy to protect your assets from a downturn in the stock market.

2. You can profit from market volatility and movement: A call option offers an unlimited profit potential in a bull market, a put option is profitable in a bear market.

3. Manageable costs: The risk to buying calls and puts is limited to the amount paid for the premium.

4. Highly leveraged investment: The cost of the premium is only a fraction of the cost required to purchase the underlying asset. This magnifies the profits when you have a winning trade.

5. Additionally, options are flexible, they can be used either as a simple trade or a complex arrangement of puts and calls. It is entirely up to the imagination of the investor as to the complexity of the trade.

Some people say that investing in stock options is nothing but gambling. And to an extent, this is true. Very few things in life are certain, but if used correctly, options can reduce the gamble of purchasing stocks or futures.