Learn about the pros and cons of using options as part of your investment strategy.
- Options offer an opportunity to take advantage of market moves, both up and down.
- They also offer the possibility of increased rates of return and a predetermined limit to the amount of potential loss.
- While options are sometimes used to hedge or reduce risk, they can be an aggressive investment and may not be appropriate for every individual.
How do those risky investments known as options work? The following provides the basics of the most common financial derivatives, call options and put options.
What is a call option?
A call option gives its holder the right to purchase a specified number of shares of stock (usually 100) at a designated price (strike price) within a set time period (expiration date). The price of the option is known as the premium. The owner of a call has the right to call forth the shares of stock and purchase the shares at the specified price. If an investor believes the value of a stock will rise, he will purchase call options.
Why not just buy the stock?
Leverage is the advantage call options offer over the direct purchase of a security. For instance, 100 shares of a $60 stock would cost $6000. However, a call options contract to purchase the same 100 shares of stock at $60 per share in 60 days may cost only $300 ($3 per call). If the stock had been purchased and rose to $65, a profit of $500 would be realized—an 8.3% return on the investment. In the case of the call options contract, if the underlying stock increased from $60 to $65, the option’s premium may have risen to $500 ($5 per call) resulting in a profit of $200 ($500 – $300 = $200)—a 67% return on the investment.
What’s the risk?
In the above example, if at the expiration date (60 days), the stock is worth less than the strike price ($60), the call would be worthless and the investor’s $300 lost. Thus, for a call to be profitable, the price of the stock must increase over the call’s lifetime.
What is a put option?
A put option provides the owner the right to sell stock at a certain price within a specified time period. It is an option to place or put with someone else shares owned by the holder of the option. Investors purchase puts when they believe the price of a stock will decline.
As with all options, leverage is the attraction. To illustrate, a put contract to sell 100 shares of a $60 stock for $60 in 30 days may cost $300 ($3 per put). If the price of the stock declined to $55 by the expiration date, the put contract could be sold for $500 ($5 per put) providing a profit of $200 ($500 – $300 = $200)—a return of 67%.
On the other hand, if the stock’s price rose or stayed at $60 by the expiration time, the investor would lose his money.
While options are sometimes used to hedge or reduce risk, they can be an aggressive investment and may not be appropriate for every individual. However, they do offer an opportunity to take advantage of market moves, both up and down, along with the possibility of high rates of return and a predetermined limit to the amount of potential loss.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. All investments involve risks, including possible loss of principal. There is no assurance that any investment strategy will be successful. Diversification does not ensure a profit or guarantee against a loss.