Options are securities that give the owner the right to buy a stock at a
specific price up until a specific day.
Options are traded just like stocks. You can buy them for most stocks
that are traded.
Option trading allows the investor to leverage their capital. For
example, instead of actually purchasing 1000 shares of a $100 stock, you
might be able to buy an option that allows you to buy that same stock
for $105 the next few months at maybe only $1 per contract. 1 Option
contract entitles the the holder of the option to buy 100 shares of the
stock. Therefore, in order to purchase 1000 shares of a given
stock, you would need to purchase 10 options. In this example,
instead of investing $100,000 to purchase the stock directly, you would
only have to spend $1,000 to purchase 10 options (10 options x $1 per
option x 100 shares per option = $1000).
If the stock goes up in that timeframe, you would
make approximately $1,000 for each $1 point move above $105. Conversely,
if the stock never gets to the $105 per share or goes down below $100,
you can loose some or all of the $1,000 you paid for the options, since
they would expire worthless.
Option Trading can be very risky, but can also be used to hedge risk.
Let’s say you have a portfolio of stocks, and you feel like there is a
lot of risk that the market will go down, but you do not wish to sell
your stocks just yet. You can buy an option called a “Put” on the S&P
500 Index,. which will go up if the stock market goes down. So in this
case, Option Trading is a form of portfolio insurance. So when the
market is down trending, the S&P should also goes down, generating
profits on your S&P 500 Puts that offset losses in your portfolio.
For the best information available on options, go to www.CBOE.com. That
is the site of the Chicago Board of Option Exchange in Chicago. They are
the home of most of the options trading in the U.S. and an authority of
this subject.
