Stock Options Basics Explanation

The first thing to remember if you're  tempted to try to trade stock options is not to rush into putting real money towards these risky investments. The leverage that stock options involve makes them appropriate for sophisticated investors only. Getting options explained for you would never be a bad thing however, as it's one of the investment vehicles you should know about if you're on the road to becoming a knowledgeable investor.

The first safety measure that one can use to reduce the overall risk to their portfolio with options is to limit their options trading budget to a very small percentage-say 5%-but their total portfolio amount. In this way you can balance out the potential large losses that you might incur with options,  against the parallel possibility that you could double or triple your money on a given position, without putting your entire portfolio at significant risk.

Buying 100 shares of XYZ stock at $30 per share would cost us $3000, and if the stock goes up three points to 33, we would see a 10% gain in the value of our position, regardless of how long the stock took to get there. With options, you might purchase the right to buy 100 shares at $30 per share for just a few hundred dollars perhaps, depending on where the stock is when you purchase the option, as well as how much time is left on the life of the option contract. Unlike stocks, stock options have a finite life and an expiration date, and this is absolutely critical when you're attempting to value options contracts.

To better understand options pricing lets look at what happens if the stock moves to $33 per share after we buy the option for say $200 when it had two months life left on the contract with the stock trading at 29.   With the stock at $33, our option is worth at least $300 because theoretically if we exercised our right to buy the stock at $30 we could immediately sell the shares at $33, profiting by $300 (100 shares times three dollars per share). Our option would also have value deriving from the amount of time left on the contract, so unless it was the very day of expiration the option would be worth more than $300. In this example you can see that rather than our 10% gain that we would've enjoyed if we had simply bought the stock, in this scenario our option is worth 50% more than $300 then when we bought it at $200.  This is the power of leverage.

The best way to begin trading stock options is to paper trade them using a trading platform that allows you to practice without using real money. The options market moves very, very quickly, and you absolutely have to get a feel for options dynamics before risking your own funds.

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