Investing in Stock Options
Investing in stock options can be an exciting and powerful way to dramatically increase the returns on an investor's portfolio. However, investing in stock options can also be very risky, so it can have a negative impact as well. The key to successful investing in stock options is to accept that stock options are a speculative investment vehicle that afford investors increased leverage and to use them as such. Their increased volatility can lead to large profits, but the vast majority of stock options expire worthless, costing their ultimate investors the entire investment.
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Function
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A stock option grants the option holder the right, but not the obligation, to purchase or sell 100 shares of the underlying stock for a predetermined price (the strike price) during a predetermined period of time. The period of time ends on the option expiration date. Stock option expiration dates are designated by the month in which they expire. Stock options expire at the close of the market on the third Friday of their expiration month.
Types
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The two types of stock options are calls and puts. Calls are purchased in anticipation of the underlying stock increasing in value. Puts are purchase in anticipation of the underlying stock decreasing in value. Calls grant the option holder the right, but not the obligation, to purchase 100 shares of the underlying stock. Puts grant the option holder the right, but not the obligation, to sell 100 shares of the underlying stock.
For example, if XYZ is trading at $9 per share and Ike the Investor thinks the stock is going to go up, he might buy a $10 call option. If XYZ goes to $13 per share before Ike's call option expires, Ike has the right to buy the stock for $10 per share and make an immediate $3 per share profit.
Likewise, if XYZ is trading at $9 per share and Ike thinks the stock is going to drop, he might buy a $7.50 put option. If XYZ drops to $5 per share before Ike's put option expires, Ike has the right to sell the stock for $7.50 per share and make an immediate $2.50 per share profit.
Time Frame
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All stock options have an expiration date. Some are very short-term (less than one month) and some are very long-term (more than one year in the case of LEAPS). The longer term the option is, the more expensive it will be. This is the time value of the option. Obviously, the longer a stock has to achieve a given price point, the more likely it will happen, so longer term options are priced higher than short-term options.
Size
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All stock options represent 100 shares of the underlying stock. It doesn't matter if the stock is $10 per share or $1,000 per share.
Considerations
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Stock options are volatile and carry a high degree of risk. While they can be an excellent way to accelerate returns, only sophisticated investors should invest in stock options, and only with capital they can afford to lose. To this end, brokerage firms must approve clients to trade options before the client is allowed to do so. The approval process usually consists of the investor verifying his investment experience and signing a stack of risk disclosure documents.
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