Most investors are familiar with how the stock market works, as a way to take a stake in the fortunes of companies listed on exchanges. Stock options are another thing though: they scare a lot of new investors, but at the same time there is an element of intrigue surrounding them, as most people have heard of a financially savvy friend or relative making multiples of their initial investment in a options position.
The primary difference between stocks and stock options can be summed up in one word-leverage. Leverage is using a relatively small amount of money to control an investment, compared to what one would have to spend to buy the asset outright. Most people are familiar with a home mortgage; it’s probably the most common example of leverage. For relatively small down payment, you may move into the home.
A stock option is the right to purchase 100 shares of stock at a given price by a defined date in the future. The “right to purchase” the stock is different from buying the stock, as, depending on several factors, the right can probably be bought for a very, very small fraction of what it would cost you to purchase the 100 shares of the stock underlying the option.
If ABC stock is trading at $100 per share and you buy an option to purchase it at $120 per share, which expires in three weeks, you can most likely pay very little money for this right, as it is probably very unlikely that the stock will have a 20% move in three weeks. On the other hand, if the stock is trading at $119 per share, that same option to purchase the shares at $120 will be worth much more. And naturally, if that same option to purchase at $120 has a year of life remaining in the contract, you will pay much, much more for the right to buy the shares at whatever so-called ‘strike price’ you choose, reflecting the increased likelihood that the stock price will reach the strike price.
The purpose of the short post was simply to give you a look at stock options basics and show how options offer you an opportunity to choose just how much leverage you would like to employ when you take a position based on a company’s stock. You can pick from a entire range of prices at which you may buy the stock, as well as just how far the future you would like to pay for the right to buy the shares.
Stock options are complex and carry with them a lot of risk. Before you attempt to try and profit from them, I strongly recommend that you get call and put options explained in a way that you understand, and limit yourself to paper trading for some months to get a feel for how the options market works.
Related posts:
