The fundamentals of options

In layman’s terms, a stock option gives an investor the right, but not the obligation, to buy or sell an underlying stock at a predetermined price for a specific period of time.  A call option allows the investor to buy the underlying stock at a specific price on the expiration date, a set point of time in the future.  On the other hand, investors can buy a put option, allowing them to sell the underlying stock at a specific price on the expiration date.

An option has two components of value, the intrinsic and time values. First is the value of the strike or peg price in relation to the underlying stock’s price (intrinsic value). If the strike price of a call is below the stock’s price, the value is the difference between the two. Conversely, if a put’s strike price is above the stock’s price the option has value.

Next is the time value of the option. This value comes from the term of the option which allows you to wait for the intrinsic value to increase; if the expiration date is met, however, and your option is out of the money or of negligible value, then your option will expire worthless

The value of an option will increase or decrease over its life depending upon the increase or decrease of the underlying stock or the anticipation of such. While options out-of-the-money, with a strike price above or below the current price of the stock may seem a risky investment, even these options move with the underlying stock and can produce excellent returns.

Profiting from options

If your investing style contains a higher level of risk tolerance and you are willing to learn how to trade them, then there are several advantages to be had with options.  First, considering that an option trades at a fraction of the value of the underlying stock, you can control a significant amount of shares with minimal capital.  This allows you to leverage smaller amounts of capital into larger gains than if you bought/sold the same value of the underlying stock. Here is a real-life example of a tremendously profitable option trade. On 9/28/07, a March 2008 Google option with a $770 strike price was purchased for $1.60 per share for 1,000 shares (1 contract) for an initial investment of $1,600. At the time, Google was trading just under $500 per share. Google proceeded to move up until 11/08/07. On that date, the option was sold for $46.50 or $46,500 for a little over 1 month gain of $44,900 or 2,900% gain. The same amount of stock would have cost $500,000 and the gain would be 40%. Now, before you go mortgaging your home to play options, whoa this was an extremely lucky play. But, you get an idea of the potential.

You can also write (or sell) options for stocks that you own to, not only lock in price gains, but also generate income for your portfolio in the form of the premium (option price) that you receive. This allows you to put your non-dividend paying portfolio to work earning option income.

In addition, options offer a substantial amount of flexibility to suit a wide range of risk tolerances.  If you are a more conservative investor, then options spreads may be a great financial tool for your portfolio. In a spread, you buy both sides of the equation, the call and put, anticipating that the underlying stock is going to move either up or down. 

The inherent risks with options

As with any other investment strategy, investing in options trading has significant risks and disadvantages.  Although the amount you can lose with trading spreads is limited, trading naked options can result in you losing more than 100% of your initial investment.

Although the options price itself is significantly lower than its underlying stock price, there are also commission costs involved with trading options.  Therefore, if you do not pick a brokerage wisely, the profits you gain from options can be quickly eaten up by commissions and fees.  A popular discount brokerage firm is www.optionsXpress.com , which specializes in options.   

Options, especially when you take into consideration potential spread strategies, can become a complicated financial instrument.  Trading options are complex, and it requires a significant amount of research to select the profitable choices for your portfolio. 

For the savvy, hands-on investor who has a higher risk tolerance and is willing to make a study of this investment, options can be a very profitable financial instrument.