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“Having Options”
Education | 30 October 2009

Before you actually start investing with and trading options, you need to understand the basic terminology (the language of options) and more about what makes them tick. For example, the factors that affect the prices or premiums, and how that relates to the price of the underlying stock.

An option is the right, not the obligation, to buy or sell a stock at a specific price on or before a specific date.

An option is a contract that derives its value from an underlying asset. That contract either gives the owner the right to buy the asset (call option) or the right to sell the asset (put option) at a predetermined price and within some predetermined time frame.

The key idea here is that the owner of an option has a right, not an obligation.  If the owner of the option does not exercise this right before the predetermined time, then the option and the opportunity to exercise it cease to exist, the option expires.

Seller (Writer)
On the other hand, the seller (writer) of an option is obligated to fulfill the obligations (requirements) of the contract if the option is exercised.

In the case of a call option on stock, the seller (writer) has given someone the right to buy the underlying asset.  The seller of the call option will be obligated to sell the stock to the call option owner if the option is exercised.  The owner of the options literally has the right to CALL the stock from you.

With a put option on a stock, the seller of the put option has given the right to sell that stock to another party. The seller of the put option is therefore obligated to buy the stock from the put option owner if the option is exercised. The owner of the options literally has the right to PUT the stock to you.

Option Examples
An option is a derivative. It derives or gets its value from an underlying asset. We are already familiar with them. Did you know that you are using a form of options as part of your daily life?  Have you purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills?  Do you pay a premium for your house, auto, and medical insurance? Then you have purchased a type of option. The fact is, options are a part of our everyday life, and have valuable application in our trading and investing.

Auto insurance, health insurance, and homeowner’s insurance are all examples of put options. These options transfer the risk of loss from the owner of an asset to the writer (seller) of the put.  Insurance companies are put option dealers.

Leverage is the term used to describe the profit or loss potential when a small amount of money controls a large amount of money. The owner of one call option has the upside potential of 100 shares by investing a smaller amount of money rather than purchasing the stock outright. If there is a 10% rise in the stock, the option can double in value.

A word of caution: leverage also increases our risk. A 10% decline in the stock can result in the total loss of what we paid for an option.

You purchase 100 shares stock @ $32 for a cost of $3,200. If the stock rises from $32 to $42 you would have a $1000 gain or a 31% increase.

Alternatively, you can control 100 shares of stock by purchasing the option at a premium of $3 per share for a cost of $300 (1 contract x 100 shares x $3 premium = $300). If the option premium rose from $3 to $11, the original cost was $300 and it is now worth $1100. You have an $800 profit, but a 266% return!

When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar profit. But your option purchase will have a significantly higher percentage return.

Diversification Of Options
The possible payoff of options can make them very appealing – even        seductive – for many investors.
Those potential returns come from leverage.

That leverage can also bring greater risk.

A ten percent increase in the underlying asset can potentially double your money in the options market. On the other hand, a ten percent loss in the underlying asset and you could go broke. Too many amateur investors or beginning traders do not take enough time to think about the potential downside before jumping in with leverage.

In the end it is all about control and choice. By having knowledge of options we are no longer limited to the buy and hope strategy.  We can now make money in any type of market situation.  We can be very aggressive or we can be conservative depending on our investing personality and objectives.  You can implement several strategies with options. They can be broken down into two groups: trading strategies and investing strategies.  After some further study and follow a disciplined method you could be on your way to being an empowered self directed investor.

Join The Conversation
The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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