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Options 101
Trading shares of stock has become as common as surfing the
Internet. But, like any financial investment, trading stock is
risky. The price can fall unexpectedly and stay down for
lengthy periods. To offset that risk, and to trade with more
funds than you have without borrowing, options are... well, an
option.
An option is a contract giving the investor the right to buy or
sell some instrument at a given price on or before a stated
date.
Options contracts are written on all sorts of underlying
assets: real property, stocks, bonds, even movie screenplays.
(Though the latter trade on a rather different sort of
exchange...)
The basic idea is simple. Invest a (relatively) small sum
today, to control something worth a larger amount today. Bet
that the price will move in a given direction before a certain
date, then sell and pocket the difference.
For example, suppose Google shares are selling at $400 per
share. But buying 1,000 shares of GOOG (the symbol for Google
stock) at $400 each would cost $400,000. That's a substantial
investment of cash, one beyond the means of the average
investor.
Even buying on margin (borrowing) would typically get you only
half the way there. Most stock brokers will lend their clients
only up to 50% of the total cost. (There are laws restricting
them, in any case.)
But, you can still 'own' 1,000 shares of GOOG. Simply buy an
option at, say, $20 per share (the 'premium'). Now your
investment is $20,000 - hefty, but within reach. (That's called
'leverage' - controlling more than you own.)
Every option has an expiration date - the date by which the
investor must 'exercise his option', i.e. execute a decision to
buy/sell the instrument or lose his invested money. Depending
on the underlying asset, and other factors, the date can be
anywhere from a day to several months hence.
Options also have a strike price - the price at which the
underlying instrument has to be bought or sold when exercising
the option.
Continuing the example, suppose the option for GOOG expires in
30 days and has a strike price of $410. The break-even price
would be $410 + $20 = $430 per share. At this point, you are
'under water' by $30 per share x 1,000 shares = $30,000.
Ouch!
(Note: 'Under water' is - obviously - not the same amount as
your investment. It's the amount you have to rise to reach
break-even.)
But, three weeks pass and Google announces some good news about
earnings. The price per share rises to $440. Now you can
exercise your option ('close your position') and sell.
The options contract price has increased as well, to $25. Your
profit is: ($25-$20) x 1,000 = $5,000. (Ignoring broker fees.)
Not bad. That's a 25% profit on a $20,000 investment. (Of
course, prices fall as well. More on risk and hedging
strategies later.)
Options aren't for everyone. They're more complicated (though
not too much), riskier, and generally involve shorter term
trades and the requirement to watch the market more
closely.
But note that purchasing the options contract did NOT involve
investing 5% ($20/$400 x 100%) and borrowing 95% of the funds.
Options contracts are a straight investment of funds, not a
broker loan.
If the price goes in the predicted direction before expiration,
you make money. Otherwise, you lose (some or all of) your
investment.
As with any investment, do your homework. Make sure you
understand how options work and what the relative risks are. In
particular, study the market for that type of underlying
instrument. Throwing darts blindly is the least successful
options trading strategy.
Good luck... or should we say, good research.
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