Stock market investments help private individuals, businesses, and public institutions create wealth and establish improved standards of living over the long term. Stocks, of course, are also identified with volatility and wild swings that track the economic cycle of boom, bust, and recovery. Investors may trade options as a tool to help themselves manage stock market volatility. Options are a class of derivative products that perform in accordance to the fluctuations of underlying securities. Be advised that options carry distinct financial risks.
Stock options are similar to retail coupons, where traders may lock in a set strike price, at which they may choose to buy and sell shares of stock for a set period of time time. Locking in a set price for a particular asset is referred to as hedging. Investors pay either purchase stock options on the open market, or own them outright through Employee Stock Option Plans and compensation packages.
Traders may exercise, or use, options until their expiration date. Stock options are liquid investments that trade on organized exchanges, such as the Chicago Board Options Exchange. The options exchanges allow traders to immediately sell off these derivate products for cash, if necessary, before contract expiration. Equity, index, and cash-settled currency options expire on the third Saturday of each month. Traders must therefore close out these positions that third Friday.
Puts and Calls
Stock options are classified according to puts and calls. Calls allow traders to purchase shares of stock and various assets at a set strike price. Alternatively, put option contracts grant rights for investors to sell stock at a set price. Investors may purchase puts to either lock in profits or avoid significant stock market losses. Sophisticated investors may also sell options, in order to generate income.
Stock options allow for leverage, where an investor may put down a relatively small amount of money, but still control relatively large amounts of assets. Be advised that each individual option contract carries rights to buy and sell one round lot, or 100 shares of stock, for a comparably small premium expense.
Option premiums are quoted in per share amounts. Therefore a $5 premium for call options to buy Stock Z at $110 through the third week of July actually implies a total cost of $500 for the contract. In January, Stock Z may actually trade for $100 in the stock market. At that time, an investor would need to put up $10,000 to purchase 100 shares of Stock Z. Through one stock option contract, however, a trader can still effectively gain control above 100 Stock Z shares for a mere $500.
In The Money
Traders exercise options when they are in the money. Being in the money, of course, will take your premium expense into account. In the prior example, the Stock Z options are in the money when Stock Z trades above $115 ($110 strike price + $5 premium) in the market. If Stock Z were to advance to $125, a trader may exercise options to purchase Stock Z at the $110 strike price. At that point, profits would be $10 per share ($125 – $110 = $15 – $5 option premium = $10 profit). In all, the trade would total up to $1,000 in gains on the round-lot.
A trader may also consider simply selling out of the Stock Z options for significant profits. With Stock Z trading at $125, the premium on your options may have tripled from $5 to $15 ($125 – $110 strike price = $15 premium).
Stock options are complex products that are more so ideal for sophisticated investors. Out-of-the-money stock option premiums fall towards zero as their expiration date nears. A trader would lose his entire investment, if he were to allow out-of-the-money options to expire. Options trading strategies have often been compared to casino gambling.