Buying an Option
A straight stock purchase can be a very expensive endeavor, especially if the stock is pricey. Not many people have enough room in their account to purchase 1,000 shares of a stock like Google, which is being sold in the $500-per-share range. Unless you've won the lottery and have half a million bucks laying around, you'll probably need to come up with a secondary plan in order to purchase an expensive stock.
The solution may possibly come with buying and selling options, a strategy that many people steer away from at first because of the fear of the unknown. Options are not often discussed by mainstream business programs or in business classes and many people are warned to stay away because of perceived danger. But options are like any other instrument; they're as safe as any tool once an investor learns how to use them, but dangerous in the hands of an untrained operator.
Buying an option gives an individual the right, but not the obligation, to buy a stock at a predetermined price (known as the strike price) on a predetermined day (known as the expiration date). The buyer pays an up-front fee (known as the premium) in order to enter the transaction and retains the right to complete the trade before the expiration date. If the buyer allows the option to expire or decides not to enter the arrangement, the option expires worthless.
Option trades differ from stock trades in several ways. Stock may be sold and bought at any price; you may purchase a share of XYZ stock for $21.11. Options are only sold at the predetermined strike prices; these increments range from $2.50 for stocks trading between $5 and $25, from $5 for stocks trading between $25 and $200, and from $10 for stocks trading greater than $200. The strike price is the agreed-upon purchase or sale price of the underlying stock against which an option is purchased.
Options do not trade in individual shares, as a stock does; you could buy 41 shares of XYZ stock, but such a transaction isn't possible with options. Options trade in 100-share lots that are known as contracts. A trader with one contract controls 100 shares of a stock, meaning someone with 10 contracts controls 1,000 shares of the stock.
The expiration date is the other big difference. Stocks last until the company goes out of business and they retain their value for an individual until the stock is sold or given away. Options become worthless on the third Friday of the month they expire, which means action must be taken in order to recoup any profits.
Options are bought and sold in two different ways: calls and puts. Traders who purchase a call option expect the price of the underlying stock to increase in value, meaning the value of their value of their call option will also increase. Traders who purchase a put option expect the price of the underlying stock to decrease in value, meaning the value of their put option will increase.
For example, if a trader bought a call option for 10 contracts of XYZ stock for $5 per share, the purchase price would be $5,000, since each contract would cost $500. In the option increased in value to $6, the trader could sell each contract for $600 and all 10 contracts for $6,000, a profit of $1,000.
Buying and selling call and puts is the basic building block of trading options on the market. Once an individual learns to properly sell calls and puts they can move on to the more complicated strategies.
