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How Do Stock Options Work?

March 4, 2012 by staff 

How Do Stock Options Work?, A thorough understanding of how stock options work and when to use them provides traders access to a powerful tool that can potentially increase investment returns. Brokerages such as optionsXpress, Etrade, and TD Ameritrade allow online option trading and once approved, trading options is as simple as trading individual stocks.

Stock options are used to speculate on the future price of a specific security or to hedge a position against a sharp decline. Options also utilize leverage (exposure to a securities price movement with low capital investment) and therefore can provide investors with opportunities for substantial profit. Options are derivative instruments, meaning their value is derived from another asset, in this case the underlying security, and are divided into two categories, calls and puts.
An option is a financial contract between two parties, a buyer and a seller. A call option grants the purchaser the right, but not the obligation (hence the “option”) to buy a security at a fixed price (the strike price) by some point in the future (the expiration date). For this right, the buyer the pays the seller a fee called a premium.

Receipt of the premium imparts an obligation to the seller to deliver (sell) the security if assigned. Since purchasing call contracts is the most popular and simplest options strategy, investors that wish to learn how to trade online options should begin with call contracts.
Let’s go through an easy to understandanlogy to illustrate how options work.

For example, let’s say I own a home that you are interested in purchasing, of which the current value is $200,000. However, at this moment you don’t have enough money saved for the purchase but you plan to have enough cash in the next few months. You approach me with a contract to purchase my home for $205,000 within one year from today. Since I could simply look for another buyer with the capital to purchase the home today you pay me a $5,000 premium to hold the home for the next year, the contracts expiration date. After this date our contract is no longer valid and becomes worthless. I take your $5,000 premium and am now obligated to sell you the house at the established strike price of $205,000. However, you are not obligated to make the purchase and you might find a better home and opt out of our contract, but by doing so you lose the $5,000 premium. As the one year period comes to an end you determine that the property value has increased to $250,000 because the city has developed a brand new school and shopping mall nearby. You exercise your right to purchase the home and have essentially made an immediate $40,000 profit (250-205-5). Of course, the situation could work in reverse. As the one year period comes to an end you determine the property value has decreased to $100,000. It wouldn’t make sense for you to buy it from me at the strike price of $205,000, so obviously you don’t and you lose $5,000. This is essentially the same way stock call options work, but replacing the underlying house with a specific stock.

Call options increase in value when the price of the underlying security goes up. Conversely, if the price of the security drops, so does the value of the option. One call contract typically represents 100 shares of the underlying stock. A call option provides the buyer exposure to the potential upside of the underlying security without risking a large amount of capital and therefore is considered leveraged. However, purchasing call options is not recommended for novice investors since one can lose the entire investment.
An investor wishes to gain exposure to the company Pfizer Inc. (PFE) but doesn’t wish to tie up a large amount of his trading capital. Stock options quotes can be found online at sites such as Google Finance or Yahoo!Finance. After checking the quotes, the investor could purchase a position in the company, which currently trades at $17.67/share. Therefore, purchasing 100 shares would cost the investor $1,767, a fairly hefty amount of capital. Alternatively, the investor could purchase a call option which would give him exposure to the stock without requiring a bulky initial investment. In this case he decides to purchase the Jan 21st 2012 20 call for $0.70. The strike price is 20 and the expiration date is January 21st 2012. This option grants the investor the right to purchase 100 shares of Pfizer at $20/share until Jan 21st 2012 and costs an initial investment of $70. The transaction cost is $70 because the option contract represents 100 shares (0.70 X 100). For simplicity, broker commission fees are being ignored.

The break-even price for this trade is $20.70 (20 +0.70). Therefore, the investor needs to the price of PFE to appreciate to $20.70 or higher prior to the Jan expiration.

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