Stock options are a type of investment used to gain exposure to stocks without having to purchase the underlying asset. They are a popular way to both diversify a portfolio and increase the potential for higher returns. For those unfamiliar with the concept, this article will provide a basic overview of stock options, as well as a few examples of how they can be used for investing.
A stock option is a contract that gives the holder the right to purchase or sell a specified amount of an underlying stock at a predetermined price, known as the strike price, before the option’s expiration date. The strike price is usually set at or near the current market value of the stock. Options are typically sold in lots of 100 shares, and the option buyer pays only a fraction of the cost of the underlying stock.
Stock options come in two basic types: calls and puts. A call option gives the buyer the right, but not the obligation, to buy a stock at the strike price on or before the expiration date. A put option gives the buyer the right, but not the obligation, to sell a stock at the strike price on or before the expiration date.
Options are a great way to get involved in the stock market without making a large initial investment. For example, a person might buy 10 call options for $5 each, for a total cost of $50. Each option gives the holder the right to buy 100 shares of a stock for $50, even if the stock is trading for more on the open market. If the stock rises to $60, the option can be exercised and the holder can buy the stock for $50 and turn around and sell it for a $10 profit per share.
Options can also be used to hedge against risk by protecting against a decline in the value of a stock. For instance, if the holder of a stock is worried about a decline in the stock price, they could buy a put option and lock in a price at which they could sell the stock, protecting them against any losses if the stock falls.
Options can also be used to generate income. For example, a person could sell (or “write”) a call option on a stock they already own. The holder of the option would pay the writer a premium for taking on the risk of having to sell the stock at a certain price. If the stock doesn’t rise above the strike price, the writer keeps the premium and can write another option.
Stock options can be a great way to increase the potential for higher returns, diversify a portfolio, and protect against risk. It’s important to understand the basics of stock options before trading, as there are risks associated with investing in options. However, with a solid understanding of how they work, stock options can be a powerful tool in any investor’s repertoire.