Education 01: Options Trading: What is an option? Why should I look at options for investing?
What are options?
Options are contracts that are traded like stocks. You can buy them through brokers (full-service or online). The value of an option is derived (thus the term derivative is used to classify options) from an underlying security (ie. the option value is based on the value of another investment).
In the case of stock options, the option value is related to the value of the stock the option is associated with. So an option on Apple (AAPL) stock would change in value based on the the change in Apple's stock price.
The change in stock price is only one component of an option's value. The option price is also affected by time (options have an expiration, and the closer to this expiration the lower this value becomes) and by the agreed upon price for the contract (more on that below).
DEFINITION: Option - is a contract between two parties to exchange a stock at an agreed upon price (Strike Price) by an agreed upon date (Expiration Date). One party pays for the rights and the other party collects that payment and agrees to commit to the transaction.
The reason it is called an option is that the party who pays for the rights has a choice to go forward with the contract or not. If the party elects to not go forward, they give up the amount they have paid, but have no further obligations. The party that collects the payment does not have this choice. They must comply with whatever the purchaser chooses.
Why should I look at options for investing?
Options offer a greater reward than stocks, but also experience higher risk. A value of an option can increase/decrease 50-100% within days, even if the stock it is associated with moves only a few percent.
For someone who follows investing closely, options can be a great tool to enhance the returns on your portfolio.
Example: If you own 100 shares of Microsoft (MSFT) stock, and you believe the price is going to go up in the short-term. If MSFT is trading at $50/share, and you wanted to increase your holdings to take advantage of the stock price going up, to purchase another 100 shares would cost you $5,000.
However, you could purchase an option (CALL Option) that gives you the right to buy MSFT at $50/share until the 3rd FRI in April (APR CALL contract). This contract might cost $1.00/share, and each contract is for 100 shares. So, to get the same benefit of owning 100 shares, you could buy 1 Call contract for a cost of $100.
Now, if the price of MSFT goes up, the value of this contract will go up. AND, if the price of MSFT goes down, the value of this contract will go down. The most you could lose is the $100 you paid, but if the price of MSFT goes up, you get the benefit of the price increase on 100 shares, without putting up $5,000.
So, if you are interested in investing, and are good at predicting the direction a stock price is headed, options offer a terrific way to enhance the results in your portfolio, without using too much capital.