Stock options were formerly considered best left to stock trading professionals. But these days, trading stock options is almost as easy as buying and selling shares of stocks or mutual funds. Stock options are even allowed in self-directed Individual Retirement Accounts (IRA's). Even as options have become easier to access and trade, they may still be better suited for professional traders, due to their higher risk profile than traditional equity trading. Whether or not you choose to use stock options in your portfolio, it is a good idea to understand the purpose behind stock options, how to invest with them, and their many benefits and risks.
What is a Stock Option?
A stock option is a security that gives you the right, without requiring you to exercise that right, to buy or sell a security, usually a stock, at a price known as a strike price or exercise price, within a certain period of time or on a specific date. Companies often give their employees stock options. The stock option will take the form of granting the employee the rights to buy, for example, 1,000 shares of company XYZ at $10 per share in approximately 2 years on March 15. XYZ company may be trading currently as high as $30, making these stock options worth roughly $30-$10 = $20 each if the stock price holds. Most of us are not involved with stock options from our place of employment, but rather we buy and sell stock options on the market.
The benefit to buying and selling stock options is that they allow us to control much more stock than we might otherwise be able to with a small initial investment. By leveraging capital in this way, stock options can produce relatively high returns, but they can also result in substantial or total losses, depending on the movement in stock price.
Let’s illustrate how this would work using Google (NASDAQ: GOOG) stock, which has traded recently at around $1,000 per share. In order for you to buy 100 shares of Google you would have to spend about $100,000 to buy the shares. However, if you thought Google shares would rise in price during the term of your option purchase, but you could not afford to spend $100,000 to buy shares of Google stock, then you may decide to buy options on Google.
The primary risk with buying stock options is that most stock options expire with zero value. This means that it is possible to lose the entire amount invested in the option.
There are two types of options. A “call” gives you the right to buy the underlying security that the option is tied to by a certain date in the future for a certain price. The other type of an option is known as a “put.” A put gives you the right to sell the underlying security the option is tied to at a certain price at a certain time in the future.
If you are expecting the price of Google to rise, then you buy a call for Google generally either near its current price or perhaps somewhat above the current price of Google, with the expectation that the price of Google will go higher than the strike price of your call. If the price of Google goes over the strike price of your call before your option expires, then you have made a profit if you exercise your option.
If, however, you expect the price of Google to fall, then you may decide to buy a put option on Google. Your put option will be for a strike price below the current price of Google and will expire normally at least a month or more in the future. If Google happens to fall below your strike price of the put option that you purchased before your option expiration date, then you will make a profit from exercising the put option.
Options can get much more complicated than this basic explanation, but all options are either calls or puts. Some inexperienced investors think that the security an option is based on must hit the strike price for the option to make money. Professional option traders know that as long as the underlying security moves towards the strike price for an option, it should rise in value. Often that rise in value is enough to make a profit without the underlying security ever hitting the strike price.
Options belong in your portfolio for two potential reasons. If you happen to have a large holding in a few stocks that make up the majority of your portfolio, then options can be used for what is known as hedging those positions. Hedging refers to protecting the loss of value in your stock purchases by buying options that will counter that loss of value. The other reason you may decide to use options is if you understand how options work, including both their risks and their benefits, and wish to gain higher potential returns by trading options instead of buying and trading stocks.
The most significant danger with options is when you sell either a call or a put. If you avoid selling a call or put, and only buy calls or puts, then you will avoid exposing yourself and your portfolio to potentially unlimited risks.
As stated earlier, the primary risk with buying stock options though, is that most stock options expire with zero value. This means that it is possible to lose the entire amount invested in the option.
If the ideas presented here are not clear to you, then perhaps you are better off not having stock options in your portfolio.