An Explanation Of Stock Options Basics

In the course of trying to understanding stock options, whether we're talking about calls and puts that are traded on the Chicago Board Options Exchange, or even stock options given as part of a compensation package by companies to employees for one sort of service or another being rendered, the central idea is a slightly tricky one: options represent a right to by the company's shares at a given price, not the shares themselves. I'll leave coverage of employee stock options and SFAS 123 regulations to another article, and just explain publicly traded stock options here.

Buying vs buying the right to buy is essential to any explanation of stock options and something that is difficult at times for new investors to really grasp. Let's compare two scenarios:

On one hand we could purchase 100 shares of XYZ company stock, currently trading at $30 a share, for $3000. This is an unleveraged situation where we have to come up with an amount equal to the full value of the position into which we are buying.

If we are optimistic about the company's stock, we may instead choose to buy one XYZ company call option contract. This gives us the right to buy 100 shares of the company's stock, and let's say we choose to purchase the right to buy it at $35. We are confident it will move up quickly from here so we decide to buy an option with only (say) three months life left on it before it expires. One of the main differences between stock options and just buying stock is this expiration date; it makes any options trade tricky because it's the basis of the reason why you not only need to be correct about the stock but be correct as soon as possible. Why exactly is this?

Once you purchase the XYZ 35 strike price option contract, you'll be aware that if on expiration day three months from now if the price of the stock is below 35 the contract will be worthless. On that day, the right to buy 100 shares will have no value because no one would ever purchase a right to buy something at a higher price than where it is currently trading (unless there was time left on the option contract, time in which the stock could still move upwards, and hopefully over the strike price).

But lets say that you are correct about the stock and that the shares rise spectacularly to $40 per share within three months. In this case the value of the option contract, which you purchased for only a small fraction of what would have cost you to buy 100 shares of stock at 30, will be worth at least $500, because you can exercise your right to purchase the 100 shares at 35 and immediately resell them at $40 per share ($5 x 100 shares)

Had you bought the shares for $3000 you would see a 30%+ gain, which is outstanding in three months. But if you had purchased the right to buy 100 shares at 35 back when the stock was trading at 30, with only three months left on that right, the unlikelihood the stock would even get to 35 would have made that option very cheap, possibly only worth $100 or less. You can see that in this case, investing $100 (as an approximation) in an option that ended up being worth $500 is a 500% gain.

I've illustrated just how powerful options can potentially be, allowing you use a small portion of your available investment funds towards a given speculative position. I also hope that you see just how dangerous stock options are, and why many people who have decades of experience trading them are still unable to make money consistently through trading options, even with sophisticated option trading software.

Related posts:

1. Penny Stocks Guide To Valuation
2. Stock Option Trading – Learning the Basics
3. Trading Oil Stocks
4. Easy as ABC – Stock Market for Dummies
5. Penny Stock Trading Strategies