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What Are Stock Options and Are They Risky?

stocks Sep 05, 2018

I've been getting questions about stock options, so I decided to write a post about it!

Stock options are often misunderstood, or they are not recommended for many investors. Too many investment advisors and others will tell investors that stock options are high-risk trading. They will also say that a lot of money is lost by option buyers, which is true if that is the only strategy used by the trader.

There are ways to use options to protect profits in an account, and there are ways to use them to increase the return of stock being held in an account. There are even ways to use options to buy and sell stocks. However, this is a primer on options and why many traders lose their entire investments.

What are stock options?

This is a simple overview, and there is a lot more to learn, but options are simply as their name implies, the option to buy or sell a stock if certain conditions are met. At the basic level, there are Calls and Puts.

The Call gives the buyer of an option the right to "call" away the stock of the option seller (also called the "writer" of the option). The call holder can force the sale of the stock if the conditions of the options contract are met.

Puts are the opposite, allowing the buyer to "put" the stock, or sell it, to the writer of the put if the conditions of the contract are met. To put it simply, people can use options to profit from a rise or fall in a stock's price without owning the stock itself, called the "underlying" shares.

An option contract, Call or Put, controls 100 shares of stock, so each contract bought or sold represents 100 shares of the "underlying" stock. All options contracts have a finite lifespan, with contracts expiring at the end of that period. These contracts give the buyer the option, but not the obligation, to exercise their option contract and force the purchase or sale of stock.

In reality, the vast majority of contracts expire worthlessly. Instead of actual stock changing hands, usually, the contracts themselves end up being bought and sold for profit or loss. The attraction for traders is the ability to control and profit from the movements of shares of stock that are much more costly than the option contract.

The risky strategies in options

Buying options betting on a rise or fall in the price of a stock within the period before the option expiration is how most of the money is lost in options trading.

Buying calls means betting on a rise in the stock past a specified price, the "strike price."

Buying puts is betting on a fall in the stock below the strike price. Should the stock perform as the option holder expects, they can profit as if they owned that 100 shares of the stock, but they only have a fraction of that value invested in the premium price of the option.

Example: Calls or Puts on a stock trading at $55/share may trade at a price of $2.28 per contract on a contract expiring two months in the future. This costs the option buyer $228, that's for the 100 share contract. If the stock rises or falls as expected, they profit as if they were holding $5,500 worth of the stock itself.

A great many options run out of time and expire worthless, with the option writers keeping the premiums. That's understandable when the stock can trade the other direction or sit still, and the option buyer ends up losing their entire investment when their contracts expire. There are uses for options in protecting stock profits and in buying and selling stocks. However, learn much more about options and how their prices react to the passage of time and the movement of stock prices before diving in. As with anything, due diligence is crucial. Period.

Have questions about your strategy? Let's talk about it.Stock options are often misunderstood, or they are not recommended for many investors. Too many investment advisors and others will tell investors that stock options are high-risk trading. They will also say that a lot of money is lost by option buyers, which is true if that is the only strategy used by the trader.

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