In this stock market investing guide I am going to be telling you all about options. Today I am going to explain why you should use options and how options work.
There are two main reasons why you would use options they are to speculate and to hedge.
- Speculation – when investors speculate they bet on the movement of a security. This is where the big money is made or lost. When you buy an option you to be correct in determining the stock movement as well as the magnitude and timing of the movement, to succeed you must correctly predict if the stock will move up or down as well as how much the price will change and how long it will take for this to happen.
- Hedging – you can think of this as an insurance policy. Options can be used to insure your investments against a downturn. If you wanted to buy a stock and limit any losses you could use options to restrict your losses and enjoy your profits in a cost effective way.
How options work
Lets say that on May 1 the stock price of xyz company is $67 and the premium (cost) is $3,15 for a July 70 call, this indicated that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3,15 x 100 = $315.
Remember a stock option is a contract to buy 100 shares, that’s why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock must rise above $70 before the call option is worth anything, also because the contract is $3,15 per share the break even price is $73,15.
When the stock price is $67 its less than the $70 strike price so the option is worthless, don’t forget that you paid $315 for the option so you are down by this amount.
Now let’s imagine that the stock price rises to $78. The options contract has increased along with the stock price and is now worth $8,25 x 100 = $825. Subtract what you paid for the contract and the profit is ($8,25 – $3,15) x 100 = $510. As you can see you almost doubled your money in just three weeks. At this stage you could sell your options and take your profits.