The Basics of Options

Options are a type of investment vehicle called a derivative. The value of derivatives is directly related to the daily performance of the underlying asset for which the derivative has been bought. Most derivative contracts are written for stocks, but they can also be written for commodities, currencies, or a combination of underlying assets. An investor can make a request to purchase any number of shares under a contract, much like outstanding shares of stocks are bought.

What makes derivatives unique is that it allows the holder to exercise a “right” to buy and sell quantities of stocks without ever actually owning them. Derivatives gives brokers a lot of flexibility to invest in multiple or large company stock positions, because they can buy derivatives at a fraction of the cost of owning shares outright. There are restrictions, however.

Derivatives have expiration dates within which the contract writer is required to “buy” or “sell” their share count to the broker if the contract matures ‘in-the-money.’ If the contract expires ‘out-of-the-money’, the broker only loses the payment of the contract premium. When the stock position is ‘in-the-money’, the writer must sell from the shares they have or buy stocks for the ‘uncovered’ positions on the open market to sell to the broker.

If an investor believes a stock price will fall, he or she can ‘short’ the stock by buying a ‘call option’, the right to sell stocks. And when the market price falls, he or she will earn a profit on the price gap, or ‘spread’, between the market low and the predetermined ‘strike’ price. The contract writer is required to buy back the lower valued stock position.

Options, much like the name suggests, gives the holder the option to buy company stocks, a ‘put option.’ If the investor believes a stock to be undervalued, he or she can purchase the right to buy the stocks once it surpasses the strike price at future date and then immediately ‘sell’ at the higher, current market price.

Options markets are so large now that trading desks specialize by industry, asset type or even index.

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