Explaining Stock Options Conceptually

A pretty good education on stock options can be had just from perusing websites on the subject. It’s easy to get stock options explained to you on the Internet, but some people still have a difficult time wrapping their head around the subject. Purchasing stocks is a much easier way to take advantage of moves that we expect to see in the shares of a company, so why are stock options an attractive alternative at all?

The primary difference between purchasing stock and buying options on the same stock boils down to one word: leverage. In purchasing 100 shares of a stock at $30 per share, you have to come up with $3000 (unless you have been approved for margin purchases by your broker). With options you can control the same 100 shares, and benefit from a price move that you expect, with much less money. Here’s how:

With the stock at $30 a share you could buy a call option that gives you the right to buy 100 shares of the stock at $32.50, with a few months life left on the contract for-let’s say-a hundred dollars. If you get a price move that you expect and the stock goes to-let’s say-$35 per share, the intrinsic value of the option would be $250, because the right to buy at $30 implies that you could immediately resell at $32.50 and make a $250 profit (100 shares times $2.50).

Of course the problem is that if the stock doesn’t make it to $32.50 before your option expires, it will expire worthless, because a right to buy something at a higher price than the current market price, if there’s no time left on your option contract, is worthless. This is why you hear horror stories of losing everything that one has bet on a given options position. Indeed, this is the downside of leverage generally: with an increased possibility of profit, you also generally take on more risk.

Options are absolutely not for everyone. Even people who have been trading for decades have a hard time making money with stock options consistently. The best advice that I give you, after you get call and put options explained to you properly, is to paper trade for a few months before you commit real money to this volatile and risky investment.

Tags: put options explainedstock optionsstock options explainedstock options explanation