Understanding Stocks

WANT TO MAKE MONEY FAST? TRY THESE TRADING STRATEGIES 81
Trading Options
Although options are rather difficult to understand, with a little practice,
they begin to make more sense. That’s why many professional
traders include option strategies in their portfolios. In particular, traders
will use options to hedge their position (taking the opposite side of a
trade to reduce risk). For example, if a trader is long a stock, he or she
might use options to short the same stock. While options can seem a bit
overwhelming even for experienced investors, I’ll do my best to explain
them so that they make sense.
Think of an option as a contract that gives you the right, but not the
obligation, to purchase or sell an item. It could be a house, a commodity
like oil or corn, or a stock. One type of stock option, for example,
gives you the right to purchase a particular stock at a given price by a
certain date. The wonderful part about options is that you don’t have to
own the stock to trade them. Options are also called derivatives because
their price comes from, or is derived from, the stock price.
The two most popular types of options are the call and the put. A
call option gives you the right to buy a stock at a specified price. A put
option allows you the right to sell a stock at a specified price. You have
the right to buy or sell the underlying stock, but most people don’t exercise
this right. They simply buy and sell the option. For a fraction of the
price, you can control hundreds or thousands of dollars worth of stock.
For example, let’s say Bright Light is selling for $20 a share. You
like Bright Light, and you think it will rise to $25 a share. So you
decide to buy a call option with a strike price of $25. (You can choose
any strike price. The further away the strike price is from the current
price, the cheaper the option. For example, an option with a $20 strike
price will be more expensive than one with a $25 strike price.) If Bright
Light does hit $25 or higher, you will be “in the money.” The higher the
stock goes, the more money you will make.
There is a catch, however. When you buy an option, you also have
to specify an expiration date, usually from 1 to 3 months from the date
of purchase. This means that Bright Light must rise to or above the strike
price before the expiration date or you will lose your entire investment.