The Basics Of Stock Options
As risky as stock options are, they are only appropriate for investors with years of experience behind them, and a level of sophistication that most new investors do not yet possess. This is not to say that getting a good stock options explanation is not a smart thing to do, because sometimes the more knowledge you have on a subject the more likely it is that you will avoid undue risk. Because they involve leverage, options on stock are quite risky, and it’s possible to lose the entire investment that you have in a given position.
Many financial planners would advise you to keep the money that you are using to trade options down to a very low percentage of your overall portfolio amounts, maybe 5% or so. While you might be fortunate enough to see large gains on a given position, over time it is likely you will see large losses as well; keeping the amount you have invested low in relation to the value of your overall portfolio size is a way to keep yourself safe.
If you were to buy 100 shares of ABC stock at $60 per share, it would cost you $6000. A 10% move up to $66 per share would increase the value of your position by 10%, regardless of how long it took the stock to go to $66. With options however you can buy the right to buy 100 shares of ABC stock at $60 per share for instance, for much, much less than $6000, perhaps just a few hundred dollars depending on the amount of time that is left on the life of the option contract, as well as how far away from this so-called “strike price” the stock price is when you purchase the option contract.
With our option to buy 100 shares of ABC at $60 per share, which we may have purchased for a few hundred dollars, let’s look at what happens if the stock moves to $66 per share from $60. Since an option contract covers 100 shares of stock, the right to buy them at $60 per share would be worth at least $600 in this case. The idea is that if we exercised our option to purchase the stock at $60 we could immediately sell the 100 shares for $6600 (100 shares times six dollars per share). Rather than the low double-digit gain we would’ve gotten if we had bought the stock, we are looking at 100%-%200 gain in the value of our position, and maybe more. Depending on how much time was left on the contract, there would also be a time value amount associated with it, over and above the intrinsic value of $600. Leverage is a powerful thing.
Even if you think you have gotten stock options explained to you well, you really have to trade them for a few months without using real money. “Paper trading” as it is called, can be done by opening a brokerage account and buying and selling options in a simulated environment with simulated funding, gains and losses.
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