Stock Options 101: Understanding Puts and Calls
Stock options can be the most intimidating investment on Wall Street. Huge profits and losses can be accumulated in the natural leverage offered by stock option investing. Is this financial instrument right for your portfolio?
What are Stock Options?
Stock options are simply a contract to buy a specific stock at a particular price sometime in the future. Consider stock options to be similar to that of a down payment of a home. Buying a stock option requires you to pay a "premium" cost, which is generally a fraction of the stock price. If you are buying a home, you would "invest" by making a down payment (i.e. the "premium") to buy the home at a time in the future. From an investment standpoint, you could put down $10,000 on a $100,000 home to reserve the right to buy the home for $100,000 by next year. If the home rises to a value of $150,000, the buyer could buy the home for $100,000 and sell it for $150,000. This can be done in the same way with stock options to reserve shares at a specific price and profit from the difference if the stock price rises to the call price, or the price at which you want to buy the stock.
Puts and Calls
Puts are the option to sell a stock at a particular price, while calls are the option to buy a stock at a certain price. Instead of shorting the stock, investors can instead buy puts, which allow the option to sell a stock at the price stated in the future. Calls are for stocks that the investor plans to see rise in value over the next few months to years. The strike price is the other price stated on the bid and ask charts; a strike price is the value that is assigned to future buying and selling of the stock.
Are Stock Options Dangerous?
Many investors consider stock options to be too risky for their portfolio. A small percentage change in stock price generally results in a magnified change on the stock option. Purchasing a stock option generally means you'll pay the difference between the current stock price and the strike price. A stock with a share value of $25 per share and a strike price of $15 per share would cost at least $10, as the stock option would enable you to buy a $25 stock for $15. More than likely, the option will sell for a dollar or so higher than the difference between the current price and stock price. The example stock option above would probably sell for roughly $11 per option, giving the option writer a $1 profit on the stock option.
Stock Options Can be Used to Regulate Risk
Going back to the real estate transaction cited above, if the home value were to fall to $80,000, the buyer would have no reason to buy the home. Instead of a $20,000 loss, the investor would instead only be left with a loss equal to the down payment. Stock options work in much the same way. In times of rapidly falling stock prices, buying a stock option entitles you to the right to buy, but only at the right price. Buying a $25 share and selling for $20 would result in a $5 loss. With a stock option, you might not lose more than $1-2 with the same upwards adjustment. Stock options, contrary to popular belief, can actually be used to limit risk.