Understanding Stock Options

A Quick Overview

Understanding stock options can be a challenge, but successful option trading strategies are not as esoteric or as difficult as big men in big suits charging thousands of dollars for weekend seminars make them out to be.

Translation: You can do this.

Stock or equity options are essentially contracts that give the holder the right to either purchase shares of stock (call option) or sell shares of stock (put option) at a given price (strike price) on or before a certain date (expiration date). In almost every case, each contract represents 100 shares of the underlying stock in question.

As a stock rises, its call options gain value (and its put options lose value). Similarly, as a stock decreases in price, the value of put options increase (and its call options decline).

Options are considered decaying assets. With all else being equal, as time passes, the overall value of an option will decline. Despite their short life-span, however, they can accomplish quite a bit.

That may not be everything required for understanding stock options, but it is the core building blocks.

Within this basic framework reside a whole host of strategies and possible transactions. Options can be bought and sold in a wide variety of combinations and for a wide variety of purposes.

From basic portfolio protection to conservative income strategies to outright high-risk speculation and even complete financial self-immolation, you can use options as conservatively or as aggressively or as recklessly as you like.

Fundamentally, the most important thing to understand when studying or trading options is that the real commodity that option buyers and sellers are trading is degrees of risk.

In general, the more risk you are willing to take on, the greater your potential returns can theoretically be. Likewise, you can use options to decrease your investment risks, but the trade off is having to give up a share--and sometimes a very large share--of your potential profits. The more risk you outsource, the less potential upside remains for your portfolio.

TERMINOLOGY: If you own either a call option or a put option and choose to exercise your rights, either buying or selling those 100 shares of the underlying stock at the agreed upon strike price, your action is termed, logically enough, an EXERCISE. If, however, you are the seller of the option and someone Exercises it on you, from your perspective it's considered to be ASSIGNED. And probably not the highlight of your day. Both terms refer to the same event; the only difference is who's doing it to whom.

And finally, there are two primary advantages (or distinctions) to trading options vs. stocks:

• Flexibility - options are incredibly versatile financial instruments. There are basic, intermediate, and advanced option trading strategies for nearly every conceivable market condition and personal objective. In addition, it's also possible to adjust, convert, or repair an open options position if it begins to go against you. There's a reason, after all, that they're called options.
• Leverage - options also provide an effective and cheap means of leverage. You can control a whole lot more shares of a stock through the use of options for the same amount of money than you ever could purchasing them on margin (and having to pay interest) with your broker. It's the leverage aspect that makes option trading so potentially lucrative and so potentially dangerous (in the wrong hands, of course--I have complete confidence in your innate intelligence, judgment, common sense, and just good plain luck).