Options are financial derivative contracts that a party can sell to another party. The contract sold offers a buyer the right but not an obligation to buy or sell a security (usually a stock) at an agreed upon price. The agreed upon price is called the the strike price. An option is linked to a particular stock and will usually fluctuate in price when the price of the stock fluctuates, usually by a smaller amount..

 

The price of an option is  much cheaper than the underlying stock and this is because options are time limited, meaning they expire on a fixed date, usually the third friday of the expiration month of the contract. The expiration dates for options vary, and can range from months to 2 years. The longer the expiration date the more expensive the contract will be. Options that have expiration dates longer than 1 year are called Long-Term Equity Anticipation Securities (LEAPs) 

 

The value of an option also decreases with time when there is no change in the stock price. Option prices can also be viewed and traded just like a stock.

 

Options are cheaper than stocks but use a lot of leverage to enhance their returns, and this is one of the reasons why they are attractive to investors. For example a stock might cost $20 a share and if you wanted to purchase 200 shares of that stock you will be paying $4,000 for the 200 shares of that stock, however if you wanted to control the same number of shares for less money you could purchase 2 option contracts (each option contract contains 100 shares) on that stock at a price of $3 a share for a total of $600.

 

Financial Risk:

 

when you purchase an option, your maximum risk is limited to the original cost you pay for the option. If you purchase an option and hold it until expiration without the underlying stock moving in price, your option will expire worthless, at which time you lose your original investment. For example if you buy 2 option contracts for a price of $3 per share, your cost is $600 (3*200 = 600). This is the most you can lose in this investment.

 

Price movement in options:

An option price will change as the price of the underlying stock changes but by a lesser amount. If the strike price of a call or put is close to the price of the stock, the option is said to be at-the-money. If the strike price of a call or put is above or below the stock price, the option is said to be out-of-the money. If the strike price of a call or put is below or above the stock price, the option is said to be in-the money.

 

Types of Options: The two main types of options are the American and European option

 

• American options can be exercised at anytime between the date of purchase until the expiration date

• European options can only be exercised at expiration of the contract:

 

Uses of Options:

 

Options can be used to hedge (protect) a portfoio from losses or used to increase profits on a security .

 

An option can either be a call or put option

 

A Call option gives a buyer the right to buy securities (usually stocks) at a certain price. A call option will increase in price when the price of the underlying stock increases in price and decrease in price when the opposite occurs. When you purchase a call option it is equivalent to owning a long position in a stock because you stand to make money if the price of the stock increases

 

A put option gives a buyer the right to sell securities at a certain price, the option will increase in price when the price of the underlying stock decreases and vice versa when the opposite occurs. Owning a put option is equivalent to owning a short position in a stock because you stand to make money if the stock price decreases.

 

 

Options are risky financial instruments and thus need to only be used if you are well versed in investing.