Stock Option Investing Basics: How do options work?

Stock Option Investing Basics

So an acquaintance has told you he just made a fortune in stock option investing? Don’t get out your wallet and part with your money just yet.

Option investing without research is likely to yield the same result as lighting your cash on fire--a lot of wasted time and money. How much do you really know about this whole arena of investing...and what is it exactly?

The big difference between traditional stock investing and option investing is that traditional purchasing of stocks allows you to be a part owner in a company, while purchasing an option only gives you the right to buy or sell shares of that company’s stock.

The two types of options are calls and puts. If you have a call, you have the option to buy a specific number of shares of stock at a specified price during a set time period. If you have a put, you have the right to sell a specified number of shares of stock at a specified price during a set time period. The price specific is called the strike price and neither party is obligated to carry out their rights in this type of investment. That means someone who has a call option may buy the shares of stock at the strike price, but he or she may choose not to do so.

It is important to be able to take a loss from one investment without putting your entire livelihood at stake. Learning the basics of investing in stock options before you make any risky decisions will help you to hang on to your money and maybe even make a profit.

Stock Option Investing – What Happens Next?

It is easier to understand what happens during a stock option investing transaction if you use a practical example to understand the intricacies of this process. Imagine that Ms. Money Bags purchases a call from Mr. Cash Wad. The terms of the call specify that Ms. Money Bags may purchase 100 shares of XYZ Corporation’s stock at $10 per share any time between August 1, 2006 and August 1, 2007. If Ms. Money Bags chooses to exercise this option any time before the expiration date, Mr. Cash Wad must sell the shares to her at the agreed-upon price. How does this help Ms. Money Bags make a profit? Well, Ms. Money Bags is a smart investor--she arranged to be able to buy that stock at the $10 per share strike price any time before the expiration date. In the weeks since she purchased the option, XYZ Corporation has come up with a new method of producing their product that saves time and money. The stock has shot up to $50 per share. Ms. Money Bags purchases the 100 shares of stock at the $10 strike price and immediately turns around and sells the shares for $50 per share. From her original $1,000 investment, Ms. Money Bags has made a profit of $4,000. Sure, it seems unfair to make Mr. Cash Wad sell such a valuable stock for $10 per share, but don’t feel too bad for him. You can bet he would take advantage of the same situation in a heartbeat if he had the opportunity.

This was a basic introduction to what stock option investing is and how you can stand to make a profit. Because you need to be able to anticipate what a particular stock will do in the future, it’s a fairly risky investment. If you have a good tolerance for risk and don’t mind buying cheap stock shares and selling them for a higher value, you too can try your hand at stock option investing and (hopefully) turn a profit.

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