In order to understand what options are and how they work, we need to understand some of the terminology surrounding options.
An option is basically a contract that gives the holder the right (i.e. can choose to), but not the obligation (i.e. not have to), buy or sell a fixed quantity of shares, on or before a given date.
This right can be exercised if the holder wishes to or not as the case may be if it is not in the holder's interest to do so. For our purpose we are talking about options in the financial markets as opposed to options on houses, cars or other assets and traded on the financial exchanges.
Basically there are 2 types of options:
A CALL option is an option to BUY shares.
A PUT option is an option to SELL shares.
A CALL option generally GOES UP in price if the underlying shares goes UP. A PUT option generally GOES UP in price if the underlying shares goes DOWN.
An example of an option might be to buy Microsoft shares at $25.00 and the market price is $25.00 and the option cost is say..$1.00. If the share price of Microsoft goes up to say $30.00 then the option price may shoot up to $6.00 for example. The option could be exercised and the holder would make an instant profit by selling at $30.00 which he acquired at $25.00 via the option. The option would have reflected the $5.00 increase in the price of the underlying shares.
The initial outlay for the option is obviously less than buying the underlying shares outright and therefore the percentage gains for the initial outlay is considerably more i.e. $5 gain for an initial outlay of $1 as opposed to $5 gain for an initial outlay of $25. But beware that this a double edge sword and can work against the buyer too, but subject to the maximum loss of the premium (the amount paid for the option).
The buyer cannot lose more than the original cost of the option and this is an attractive proposition for investors. One use of options therefore is to use them as a low cost way to take advantage of expected movements in individual shares or stockmarkets as a whole.
Buying options means that you do not need to buy them with just a view of exercising them. You can instead simply sell them in the market if the price moves in your favor.
An advantage of using options is that the brokerage costs are confined to just the value of the option. You do not necessarily have to find the capital (or the underlying stock) to purchase stock from (or sell to) the person on the other side of the contract.
Also not all stocks will be suitable as options, so there is a natural selection process to eliminate the non suitable stocks. Options should be used with a view to the management of risk. The most prominent users of options are companies and institutions, whose objectives include hedging of positions against adverse movement of their portfolios.
A hedge is a low-cost "insurance" that helps to balance the counter movement of the underlying instrument. Insurance in this case means the transferring of risk from one party to another. Just as in domestic insurance, the option buyer pays a premium for the "protection" of the shares should the unexpected occurs. For instance, should the shares go down rather than up, the options transaction would compensate for the loss of the underlying. So options can provide a mechanism for absorbing risk.
What needs to be clearly understood by the potential investor in the options market is that options have quite different characteristics to the normal share market and should be bought and sold using different techniques. To regard options as simply a geared way of profiting from a movement in price of the underlying security is to court disaster.
About the Author:
The author has been trading stocks for over 8 years and has a passion about stock markets and technical analysis. To find out more about the recommended options course, visit this website:
http://www.optionstradingology.com
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350
Date Published :
Feb 20 2009