If you’re new to investing chances are you’ve heard stories about people making a lot of money very quickly with stock options. As you get options explained to you however, you’ll hopefully understand how quickly you can lose most or even all of the money that you’ve invested in a given position. You should also know that this is a game where understanding the rules well doesn’t necessarily translate into winning consistently.

Stock options come in two different flavors. Call options give you the right to purchase 100 shares of stock at a given price by a certain date in the future. Put options give you the right to sell 100 shares of the underlying stock at at a defined price by some date in the future. The idea is that rather than having to put up enough cash to buy 100 shares of stock at $50 a share, or $5000, you could buy a call option contract for maybe a few hundred dollars (or maybe ten contracts) and benefit much more from the price increase that you are anticipating.

Many variables come into play when pricing options, but the main point is that the more time remaining on the option contract that you buy, the more it will cost you. And, not surprisingly, the higher the price at which the option gives you the right to buy the stock is above the current stock price, (in the case of calls) the less the option will be worth: if the stock price never reaches that so-called ’strike price’, it will expire worthless.

Options are useful for achieving what is known as leverage, meaning that a relatively small amount of money can be used to control an asset. This means that as a percentage of what you invest, changes in the value of the asset would constitute a much larger percentage gain or loss in your investment. Home mortgages are probably the most common example of leverage. If you buy a home for $300,000 with 10% down, a 10% increase in the value of your home effectively means the that you have doubled your money (at least on paper) of what you paid as a down payment.

Stock options are very risky and you should only attempt to trade them if you fully understand those risks. Spend some time paper trading options, possibly with the aid of some stock options trading software to really get a feel for not only the potential dangers but the potential rewards as well.

    Posted in Investing from Investor on 24. Aug. 2010