Why would one invest in stock options rather than simply buying stocks? If you have heard horror stories of people losing everything they’ve put into a position you might be wondering what the big attraction is about buying stock options.
The attraction is leverage. Leverage means that you need less money to benefit from a given move in the price of an underlying investment, whether we are talking about real estate, commodities, options or other financial instruments.
If we took $1000 and bought shares of a stock with it, we would be pretty happy with the 15 to 20% appreciation in our investment in the course of a year, for instance. This is a very respectable annual rate of return.
With stock options the same move of 15 to 20% in the underlying security could double or triple our money, or give us even greater returns, depending on the specifics of the trade and how long the move took to happen after we initiated our position. The fact is however, that if we bought an option with a rather short length of time until expiration, we could be completely right about the stock going up and still lose 100% of our investment.
With options the critical thing to understand is that you are trading the right to buy or sell a stock at a given price by a certain date in the future, and not the stock itself. The value of that right is affected by factors that do not come into play for an owner of shares of stock: How far is the current price of the stock away from the “strike price” at which the option gives us the right to buy the stock? How much time is left until the option expires, and how does that length of time affect the likelihood that the stock can reach the strike price, so that it has some intrinsic value by the time it expires? There are many other subtleties that affect options pricing as well, beyond the scope of this short article.
Stock options have their place in the portfolios of some investors. Having had stock options basics explained adequately to you would be the first requirement to trading them. But it’s just the tip of the iceberg. Options are one of those games that one can seem to get no closer to winning consistently, even after understanding the rules quite well. The best advice I can give, once you think you understand puts and calls, is to paper trade for months, not weeks, before investing real money in them.
Related posts: