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When you buy an option, your maximum risk is losing the entire amount of your investment in that option. The worst outcome is that you hold the option until expiration, at which time it has become worthless because the stock price failed to move in a beneficial manner.
For example, if you buy one option contract for a price of $2 per share, your cost is $200 (2 x 100 = 200). This is the most that you can lose. Compare that dollar risk with the risk of either owning or shorting 100 shares of stock. When the stock price undergoes a substantial move against your long or short position in the stock, the dollar loss will be much greater than the cost of a call or put option.
A major risk with options is that you invest heavily by purchasing numerous contracts and then allow them to expire worthless. This represents a 100 percent loss on a significant investment. Of course, it is rarely necessary to lose all of your original investment when the stock does not move as expected. Typically, you can sell your options before expiration and recover some part of your original cost.
As the stock price changes, the option price also changes, but by a lesser amount. How closely the change in the option price matches the change in the stock price depends on the reference price designated in the option contract. This reference price is called the strike price.
When you decide to purchase an option, there will be several strike prices from which to make a selection. For most stocks, the strike prices of its options are set at $5 increments within the broad trading range of the stock. For lower priced stocks, strike prices can be offered in increments of $2.50, whereas options on higher priced stocks can have strike price increments of $10.
There is a terminology used by options traders to describe the relative relationship between the stock price and the strike price of an option. If the strike price of either a call or a put is close to the price of the stock, the option is said to be at-the-money. If the strike price of a call (put) is above (below) the stock price, the option is said to be out-of-the-money. If the strike price of a call (put) is below (above) the stock price, the option is said to be in-the-money.
Theoretically speaking, for an at-the-money option, the price of the option will change by about 50 percent of the amount of change in the stock price. For an out-of-the money option, the price of the option will change by less than 50 percent of the change in the stock price. The price of an in-the-money option will move by more than 50 percent of the change in the stock price.
For example, suppose XYZ stock is priced at $49 and a call option with a $50 strike price is purchased for $2 per share. If the price of XYZ stock rises by $2 up to $51 soon after purchasing the option, the price of the call would typically increase by about $1, raising its price by up to $3 per share. Suppose instead, a call option with a $55 strike price was purchased for $.75 per share. Then the same $2 move in the stock price might increase the price of the call by only $.20, up to $.95 per share. On the other hand, a call option with a $45 strike price and a cost of $5 per share might see an increase in the price of the call by as much as $1.60, up to $6.60 per share.
Of course, if XYZ fell $2 from $49 down to $47, the call option with a $50 strike price could be expected to lose about $1 per share, reducing its price from $2 down to $1. This illustrates how the leverage of options works in both directions.
One reason options are less expensive than stocks is that they are time limited. A long or short position involving stock can be held indefinitely, but an option expires on a fixed date. The expiration date is typically the third Friday of the expiration month designated in the option contract. When you buy an option, you can select from various expiration months, including the current month as well as other months going out possibly as far as two years.
The longer you want to hold an option, the more expensive it will be. If a price of $1 per share applies to an option expiring in two months, a similar option expiring in four months might be priced at $2 per share. For 12 months, the price could be as much as $7 per share, but even this would typically be a fraction of the stock price.
Another important aspect of being time limited is that the value of an option will decrease with time when there is no change in the stock price. If you buy an option for $1 per share with two months until expiration, for example, it might be worth only $.65 with one month to go if the stock price has not gone up. This is one of the risks of owning an option, namely that its value diminishes over time when the stock price remains unchanged.
Options typically cost only a fraction of the stock price. If you think XYZ stock, currently at $49 per share, is going up in price, you can purchase 100 shares at a cost of $4,900. If instead you buy 1 call option contract (1 contract represents 100 shares of stock), you might pay only $2 per share for a total of only $200 to participate in an upward price movement of XYZ.
Analogously, if you think XYZ is going down in price, you could short 100 shares of stock, but that creates a margin responsibility in your brokerage account, which can become costly if XYZ goes up. If instead you buy one put contract, you might pay just $2 per share for a total of only $200 to participate in a downward price movement of XYZ.
To understand the basic concept of options, let’s start with a simplified look at how they work.
An (equity) option is linked to a specific stock. The price of the option is much less than the price of the underlying stock, which is a major reason for the attractiveness of options. If the price of the stock changes, the price of the option will also change, although by a smaller amount. As the price of a stock goes through its daily ups and downs, the price of an associated option will undergo related fluctuations.
The price of an option can be viewed and followed in much the same way as a stock price. There are numerous online services, including the data feed for your brokerage account, that provide the prices of options. The Chicago Board Options Exchange (CBOE) offers a free online service for quotes on option prices that are 20 minutes delayed.
For a call option, if the stock price goes up, the option price also increases. If the stock price goes down, the price of the call decreases.
For a put option, if the stock price goes down, the option price increases. If the stock price goes up, the price of the put decreases.
This sounds like owning a call option is similar to holding a long position in the stock, because you have the potential to make a profit when the stock price goes up. And owning a put option is similar to holding a short position in the stock, because you have the potential to make a profit when the stock price goes down. In a rough sense, this analogy is true, but there are some significant differences.
OPTION BASICS: Why should someone who invests or speculates in the market learn to use options? The simple answer is that options may greatly enhance your profit from stocks and/or provide the means to help protect your portfolio.
Suppose you buy a stock for $30 a share and it goes to $33. The stock price has risen by 10 percent and accordingly you have a 10 percent profit. That’s nice! If instead of buying the stock, you buy an appropriate option, you might make a 100 percent profit or even more for the same 10 percent rise in the stock price. That’s better than nice. That’s fantastic!
Of course, there are risks associated with options, just as there are risks with any investment. You need to understand the risks as well as the advantages of options in order to optimize your results.