Investing 101: What Are Your Options?

Investing Advice

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Most traders have heard of options, but few really understand them. And while the old adage that “a little knowledge is a dangerous thing” applies here, it makes sense to at least have a basic knowledge about options and how they work.

First, let’s define the main concepts. An option is the right, but not the obligation, to trade shares of stock.

An option costs only a fraction of the cost to buy 100 shares. For example, after the trading day closed on August 10, 2010, McDonald’s (MCD) shares were selling for $72.84, so that 100 shares cost $7,284. But you could control those shares by buying one 72.50 September call for only $157, or about 2% of the cost of buying those 100 shares. You would buy that option by paying $157 through your brokerage account and putting in a buy order and paying for the call up front.

As this example shows, every option you buy controls 100 shares of stock. Options contracts are intangible, meaning they have no physical value and are only contracts and promises to buy or sell. They can work as high-risk speculative moves or, on the opposite end, as practical strategic tools for managing your portfolio and even reducing risk. But before jumping into an options trade, you need to master the basics and, at the very least, understand the risks first.

There are dozens of possible strategies for using options contracts in a variety of buying, selling, and combinations of both, which makes options trading attractive, potentially profitable, complex, and dangerous. We list several of the most popular strategies below.

A call is the right to buy 100 shares of a specified stock by or before a specified date and at a fixed price. A put is the opposite, the right to sell 100 shares. If you buy a call, you can either sell or exercise the contract before its expiration date. For example, if you buy a call granting you the right to buy 100 shares at $30 per share by or before February (a Feb 30 call), you may sell that call if the stock price moves higher, and make a profit from the higher value of the call. Or if you decide to exercise, you buy 100 shares. For example, if you own a Feb 30 call and the underlying stock price rises to $38 per share, by exercising the call, you buy 100 shares at the strike price of $30.

The opposite example is buying a put. You do this if you think the stock price may fall. For each point the price of the underlying stock falls below the fixed strike price, the put will gain one point in value. For example, if you buy a March 55 put when the underlying stock is at $57 per share, you are speculating that the stock price will fall before the put’s March expiration. If the stock does indeed fall to $48 per share, you can do one of two things. You can sell the put and take a profit; or if you already own 100 shares, you can exercise the put and sell those shares for $55 per share, seven points higher than their current market value.

There is much more, of course. The value of an option, called its premium, changes for many reasons beyond the movement of the stock. Time plays a role, and the farther away from expiration, the higher the time value will be. However, time value declines as expiration approaches, a big problem if you own the option. Volatility also affects prices of the option.

Options trading is intricate and complex. Novices can get into it, but only with study and practice. The best way to practice without risk is to paper trade (trading a virtual portfolio without putting any real money at risk) as a means for learning how options markets really work. One of the best free paper trading sites is offered by the Chicago Board Options Exchange (CBOE).

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

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