A short explanation of stock options is easy enough to obtain on the Internet, but once you get the concepts understood, you should be aware that this is one game where understanding the rules doesn’t necessarily increase your chances of success. Stock options are useful for adding some leverage into your portfolio, but should only be bought with a very small portion of your investment funds-say 5% or less-and only when you have paper-traded options for some time.
What is the difference between buying shares in a company and buying put or call options on those shares? Maybe an example will help: if I buy 100 shares of XYZ at $30 I will pay $3000, and if the price of the shares increases to $33 per share, I make 10% on my money when I sell, whether it takes two weeks or five years for this to happen.
With options things are a lot more complex. A call option gives us the right to purchase 100 shares of XYZ at a given price, by a given date in the future. The fact that this right expires by that date means that the value of the right, or the option, will be deteriorating as the value of that time remaining dwindles. If by expiration the price of the stock is below the “strike price”, the price at which we have the right to purchase the shares, then obviously the right to buy the shares at the strike price will be worth nothing, since we could simply buy them for less on the open market. For this reason, it is possible to lose your entire investment when purchasing options.
On the other hand, let’s say that we pay $200 to buy an XYZ option with this $30 strike price with one month remaining before expiration. And if by expiration of stock rises to $33 as in our example, we know that the value of our option will be $300 (100 shares times three dollars above the strike price). In this case we could very quickly make a 50% gain on our investment.
I have tried to sketch out in very simple terms just why options are so risky, as well as how easy it is to make quite a lot of money quickly, relative to the amount that you invest. The best advice I can give you is to be extremely careful in trading options through online brokers that tempt you with the possibility of huge profits. Educate yourself first. This is an online business games that is extremely risky and unforgiving, with real financial consequences!
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