Stock Option Investing and Trading
An equity or stock option is a contract between a buyer and sell, where the buyer owns the contract and has a right to buy or sell the stock at a set price. This type of trading and investing product carries risk to the amount of money invested in the contract.
There is significant trading volume in the options market. These securities have a limited time frame for investors to either trade them back or exercise them.
Stock options expire monthly and carry 100% risk to the premium (cost). When an investor buys an option, they can lose their enitre investment if the contract does not perform well enough to be profitable.
The two types of options are Calls and Puts. Call option contracts give the holder the right to buy the stock at the strike price. For a person who is trading calls, they have an unlimited gain - since the market can rise to an unknown level.
Put contracts are for bearish investors who feel the market will decline. They give the holder the right to sell the stock at the strike price.
Most option investors do not exercise the contracts. They usually see easier trading opportunities to buy or sell the contracts itself back to the market for a premium gain. Some traders will exercise the option if they want to own the stock beyond the expiration date of the contract.
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Many investors will look to sell or short option contracts. The goal here is to gain the premium for selling and hope the options expire. Options can also be used as hedging or income strategies with stock they already own. Covered Call Writing is one strategy that is used on held stock.
Most broker dealers will set up an options trading account for their customers. However, certain risks must be disclosed prior to trading.
The cost (current price) of an option contract to buy or sell is called the premium.
The premium is affected by 2 main factors:
1. Time remaining on the contact (expiration)
- The longer the expiration, the more valuable the option
Ex: 1 DEF NOV 60 CALL vs. 1 DEF DEC 60 CALL
The December contract has a longer “life” in the market, thus will have a higher premium.
2. Strike price vs. the current market price (“In the money” potential)
- More “in the money” equals higher premium
- The lower strike price call carries higher premiums
- The higher strike price put carries higher premiums
Ex: 1 JKL JAN 70 PUT vs. 1 JKL JAN 60 PUT
* The “70 Put” has 70 points of intrinsic value potential. Thus will have a higher premium.
The 3 “ACTIONS” of options
1. Holder or Writer can trade the option back to the market for premium gain or loss
2. Holder (only) can choose to exercise the contract for it’s full benefit and value or trade the option to the market
- Call holder has the right to buy the stock at a fixed price
- Put holder has the right to sell the stock at a fixed price
3. Holder (only) can choose to let the contract expire worthless. This is the holders worst case scenario.
“Holder’s gain = Sellers loss”
“Holders loss = Sellers Gain”
Options are a unique security, with unique risks. Options expire monthly with a maximum standard life of 9 months. Unlike most other securities, your initial investment can be lost in a short period of time. The holder can lose 100% of the premium paid. The writer is in effect selling short, which in some circumstances can produce an unlimited loss potential. These losses cannot be recovered on the contract once the contract expires.
Since Options are one of the riskiest types of investments, suitability and education must be the initial priority of any registered representative looking to present them to customers.
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