Options to Purchase Stock Equity Investments
Stock represents ownership in a company. Investors typically earn income from stock ownership in two primary ways: capital appreciation and dividend income. Capital appreciation occurs when the price of the stock rises. Dividends represent a pro rata share of profits earned by the company that are paid to the individual stockholders. Investors may also purchase options to buy stock, which may limit their risk while permitting them to participate in the stock's capital appreciation.
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Types
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Two primary types of options are available to individual investors: call options and put options. Put options give the option owner the right to sell the underlying stock at a specified price. Call options give the option owner the right to purchase the underlying stock at a specified price.
Features
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Call options, which give investors the right to purchase the underlying stock at a specified price, have two sets of values: time value and inherent value. The option's inherent value is tied to the price of the underlying stock and moves in tandem with the stock's price movement. The option's time value decreases as the option moves closer to the expiration date.
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Function
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Investors pay a premium for a call stock option, which is usually much less than the actual price of the underlying stock. The call option involves two primary components: the strike price, which is the price at which the option holder may purchase the shares of stock, and the expiration date, which is the date after which the option can no longer be exercised.
Benefits
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Stock may increase or decrease in value. A call stock option allows the investor to limit her liability to the price of the option. If the underlying stock decreases in value, or fails to increase in value, the most the investor can lose is the cost of the option. If the underlying stock increases in value, the value of the option typically increases as well. Once the price of the stock equals the strike price of the option, it is referred to as being in the money. At this point, the price of the option tends to move in tandem with the price of the stock, providing the option holder with unlimited profit potential.
Warning
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Buying and selling stock options is considered appropriate for seasoned investors who are aware of the risks. Past performance is never a guarantee of future results. Investors may lose some or all of their investment.
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