An investment portfolio is a fantastic way to grow your savings and make wise financial decisions for your future. One type of investment, in addition to just general stock investments, is the stock option. Read on to learn more about what it is and how stock options work.
What are Stock Options?
A stock option is a contract between two parties that gives the buyer the right (but not the requirement or obligation) to purchase and sell stock at a set price within a certain timeframe. Typically, the options represent 100 shares of the stock.
Put and Call Options
A put option is when a buyer signs a contract to sell a stock for an agreed-upon price on or prior to an agreed-upon expiration date. A call option is when a buyer enters into a contract to buy a stock at a given price by a given date. The buyer of a call option believes that the stock will increase in value before the date, while the seller thinks it will decrease. If a buyer believes that a stock will decrease in value before he sells, then he enters into a put option. The agreed upon prices in both cases are called “strike prices.”
Call option buyers profit when the strike price of the option is below the current market value. Put option buyers profit when the strike price of the option is above the current market value.
Employee Stock Options
Many employers offer their employees stock options, that have both similarities to and differences from put and call options. In most cases, an employee must remain employed for a set amount of time before he can purchase his options, and a grant price is used instead of a strike price – a price that equals the current market value at the time that the employee receives his options. These options are shares of the company’s stock, which can be a good incentive if the company is doing well and is likely to continue.
Perks of Stock Options
There are a lot of perks to option trading – greater financial leverage, chance at proactive trading instead of reactive and the chance at using them to hedge your losses.
Disadvantages of Stock Options
If you plan to use stock options in your portfolio, please make sure to understand how it works. Unlike the stock market, the options market is a zero sum market. This means the total gains on any option across the market equal the total losses on that option. If you adjust for commissions, on average options investors lose money.
Additionally, because of the leverage, you can lose more than your investment in options.
Consider using stock options as a way to diversify and strengthen your portfolio as part of a carefully designed hedging program. At Value Stock Guide, we do not recommend using stock options for speculative purposes.
