Basic Stock Options Concepts
If you think you’ve got a pretty good understanding of the stock market and have been thinking about learning about other investments, stock options are a natural enough place to begin. Options are complicated and they are also risky, so please make sure that once you get call options and put options explained to you, please paper trade for a while before using any real money in this sophisticated game.
Unlike stocks, with options you’re actually buying or selling the right to purchase 100 shares of stock at a certain price by a defined date in the future (in the case of call options), rather than the stock itself. That is one of the hardest things for new investors to understand about stock option basics, but it holds the key to really getting a handle on options. Rule number one is that a rise in the price of the stock doesn’t necessarily equate to the amount of increase in the price of an option related to that stock that you might expect.
Many things feed into the valuation of an option, including the amount of time left until the option expires, as well as how far above the current stock price is the price at which the call option gives you the right to buy the stock. For example, with XYZ stock trading at $15/share, if you own an option that gives you the right to buy the stock at say $25/share with only a month left on the option, it stands to reason that your option won’t be worth very much because it is very unlikely that it can reach the so-called ‘strike price’ before it expires. “Out of the money’ options like this are the riskiest options of all, though many investors like them because they are so cheap that if the stock moves in the direction that you expect you might double or even triple your money in a short amount of time.
Most investment professionals agree that the best way to approach options investing is by allocating only a very small percentage of your overall portfolio-say 5% or so-toward options. While the leverage is attractive, the flip side of leverage is increased risk, and there is a limit to how much you want to subject your portfolio to this amount risk.
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