What is an Option?

First off, don't be put off by options.  There is a slew of comments floating around out there like "my uncle lost everything" or "those things are so dangerous".  While it is possible that you could make a bad trade options are an extremely powerful tool that when used properly can really strengthen your portfolio.

Lets get some basics out of the way.  What is an option?  In laymen terms buying an option is akin to renting a stock for a period of time.  Think of renting a house.  For a monthly premium you can live in a house but at the end of the lease you never really owned anything.  It is the same way with buying options.  You can buy an option and take advantage of any movement of the underlying stock either up, down, or steady but at the maturation date you never really owned the stock.  There are two basic types of options Call and Put.  Though there are many strategies for using them the basic idea is that a call option allows the owner to buy stock from the stock owner at the option's strike price and a put option allows the owner of the option to sell the stock at the option's strike price.  What this means is that if you buy a call option ant the price of the stock increases greater than the strike price you can exercise the option to make money and if you buy a put option and the price of the stock decreases below the strike price, you make money.  The first thing to remember about options is that you must exercise them before the expiration date.

Next question: so how do I use these options to benefit myself and my portfolio?  Wow, what a question.  This question will take some time to answer in full and I must apologize now for this post is going to be long, but I plan to make it as concise and understandable as possible.

Basically, by renting a stock for a fraction of the cost of buying a stock you can take advantage of the same profits as owning the stock thus earning a significantly greater percentage of your initial investment.  For instance, if person A owns stock XYZ at a current price of $1 and sells a call option on that stock at a strike price of $1 to person B for $.10 and in a week the price of the stock goes to $1.50.  Person B can now exercise the option and buy the stock from person A for the strike price of $1 and immediately sell the stock for $1.50 making $.50.  Subtracting the initial cost of the option person B made a net profit of $.40 from an initial investment of $.10 thus 400% return on investment.  This is contrasted against purchasing the stock outright for $1 and increases to $1.50 netting $.50 in profits on an initial investment of $1 thus a return on investment of 50%.

An other popular way to use options is to complement the use of stocks themselves.  For instance if a person owns some stock that person can sell a call option on that stock instantly making money equivalent to the selling price of the option.  If the stock increases in price the owner makes money from the increase in the stock price up to the strike price and the selling price of the option.  If the price of the stock decreases the owner does not loose money until the stock decreases more than the value of the option, in other words, hedging.  Put options can be used in the same way to hedge against loss by buying a put option at a strike price lower than the current stock price so that if the stock decreases in value you can sell your stock at the strike price of the put option.  In layman terms call options hedge against small decreases and put options hedge against large decreases but don't hedge against small decreases.

CoffieGuy