Options are derivative securities, which means their value is based on the price of other securities. On the speculative side, options allow investors the opportunity to make a leveraged bet on the direction of stock movements. But options can also be used to hedge an existing long position or short position in stocks. Here’s a look at the basics of options trading, including how options work and how they can be used.
What Are Options?
Two types of options exist: Call options and put options. Buying call options gives you the right to buy 100 shares of the underlying stock at a certain price within a specific time period. Buying put options is the same, except your right is to sell the stock, not buy the stock. When listed in print, an option quote looks like this: IBM Jan 150.
If this is a call option, it means you have the right to buy 100 shares of IBM stock at the strike price of $150 per share before the option expires. If it is a put option, you have the right to sell 100 shares of IBM stock at $150 per share before the option expires.
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Options have two price components: intrinsic value and time value. If you have an IBM Jan 150 call and the stock price of IBM is currently $155, your option has $5 per share worth of intrinsic value. Because options contracts offer the right to control 100 shares, the intrinsic value of your option would be $500.
But options always cost more than their intrinsic value because time value is added to the price of options. The more time you have before your option expires, the more chance you have that the stock price will move in your direction, thus increasing its time value. Options that expire in nine months will have more time value than options that expire in one month, for example.
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Uses of Options
Options can be used to generate speculative gains. Let’s say it’s October and the price of IBM stock is currently $140 per share. If you think the price of IBM will go up, you might buy the IBM Jan 150 calls. With the stock at $140, there is no intrinsic value, but there is time value, which might be $3 per contract. If the stock moves up to $182 per share by the time the option expires, the intrinsic value would be $32 per contract, because the stock is $32 above the 150 strike price. Thus, although the stock moved up 30 percent, from $140 to $182, your option gain might be over 1,000 percent, as the contract price went up from $3 to $32.
You can also use options to hedge your portfolio. If you already own IBM stock, you can sell a call and receive the premium, which is the cost per option sold, generating income. If IBM stock never reaches the strike price, you keep both the stock and the premium. You could also hedge by buying a put option. If your stock trades down in value, the put option will go up in value, helping to hedge your loss.
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Futures vs. Options
Futures are similar to options, in that both have strike prices, expiration dates and are leveraged investments. However, the main difference is that futures contracts are an obligation to buy or sell a security at a certain price on a specific date, whereas buying options gives the contract owner the right but not the obligation to buy or sell.
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