What are Options and Why Should I Care?by Jody S. Ginther
Options are contracts. Generally, investing in options will require more study than casual investment in stocks. There are possible rewards and advantages of option investing over stock purchasing that make some investors focus entirely on options trading.
When you buy and option, you are buying the right to buy the underlying stock at a specific price. As a buyer, you don't have the obligation to buy the stock. Huh? It's like agreeing to buy a car within the next six months. If you tell the owner of the car to wait and see if you buy it; he will probably tell you to get lost. But, if you paid him a little money or a deposit, (for example; $200), now for the right to buy it at a certain price, (for example; $10,000), within six months, he may agree. If you change your mind and don't buy it before the six months has expired, he can keep your deposit. However, if the value of the care went up to $15,000 within the six months, he still must sell it to you for the agreed price of $10,000. He is obligated to sell it to you, but you are not obligated to buy it.
If the value of the car goes down to $7,000 within the six months, you may choose not to buy it and let him keep your deposit of $200 rather than loosing even more by buying the car.
With options, letting them go until the expiration date is referred to as letting them expire worthless.
By this example you can see some advantages of simple options trading. You can leverage a higher dollar amount with a lower investment. You were able to hold the right to buy a car worth $10,000 with only $200. However, with this leverage, you also don't own anything; only the right to buy it at a set price.
What Kinds of Options are There?
There are two main types of options; calls and puts. A call option is like the example above; it gives the holder of the option the right to buy the underlying stock at a certain price within a certain time period.
A put option is the right to sell stock at a certain price within a certain period of time.
You can buy a put or buy a call. Some people choose to sell a put or sell a call. Selling or "writing" options is very dangerous unless you are at an advanced level of understanding options. This article will not deal with the complexities of option selling.
When do I buy a Put and when do I buy a Call?
Of course, the idea is to end up with more money than you started with. If you expect the price to go up, you would buy a call. It is like taking a "long position" in stocks. You buy it with the expectation that you will make a profit when the price goes up.
Buying a put option is like a "short position" in trading stocks. You buy it with the expectation that the price will go down. Huh?
How do I make money on things going down in price?
In the stock market you can sell things you don't own yet, with the promise to buy it at a later time to cover the sale. It is like borrowing it from a friend to sell it, on the promise that you will replace replace it within a specific time. This allows you to make money on things going down in price. For example; your friend allows you to borrow his car to sell on the promise that you will replace it with the same kind of car within a certain time. You sell his car at $30,000 and the price of that car drops to $20,000 within the time you agreed to replace it. You quickly buy him another car at $20,000 and walk away with $10,000 profit because the price went down.
We will cover more terminology and basics of Options in future articles.