Can some one explain how options work?

Question

Can some one explain options and how speculative they are. Thx

Answer 1

Here's the best explanation that I have found and use it quite often when educating my students about options trading. Beware, it's not for the timid investor. You can make a lot of money but you can also lose a lot. Unless you know what you're doing, stick with stock and mutual fund buying. It's safer and will generate good results with little effort.

The main reason that options are highly speculative is that you are not only betting that the stock will go up or down but that it will do so within a specified time period. Thus, timing is everything when it comes to options trading.

Answer 2

Options are puts and calls. You buy a call when you expect the price of the stock to go up. You buy puts with you think the price will go down.

A call is a request to purchase a security (stock for example) with the expectation that to make money, the stock will go up in value and then be sold.

A put is a request to BORROW a security with the expectation that to make money, the stock will go down and you can then return the borrowed stock and make a profit.

Here's out a put works (just an example).
You BORROW 100 shares of a stock that is selling $10 per share and sell all of them. You then pocket $1000 (100 shares x $10).

You then wait 3 days and, lucky you, the stock goes down from $10 to $5. So you take your $1000 and you buy back 100 shares. But this only cost you $500 (100 shares x $5).

You then have $500 in cash and 500 shares. You give your 500 shares that you borrowed back to the person/company that you borrowed them from and you bank the $500.

You actually MADE MONEY by the stock value going down.

Regarding your question on how speculative option are, covered calls are the least speculative. The worst that can happen is that you have to sell your stock at the agreed upon strike price. Buying puts and calls are at the next level of risk. Here the most you stand to lose is what you paid for the option. Selling puts and call has unlimited risk. Most brokerages will not allow you to sell options until you can show proficiency in buying option.

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Answer 3

An option is nothing more than a contract dealing with buying or selling stock. There are two types of options calls and puts. A call is a contract that you can purchase that says that you can buy a certain amount of stock for a set amount. If the actual value of the stock changes then it will not change what the agreed price on the option was. Lets say you buy an option for 100 shares of Wal-Mart stock. The call has a strike price (The amount that you can buy the stock for) of $50. This means that if you chose to exercise the option then you can buy 100 shares of Wal-Mart stock for $50 per share, or $5000. That does not do you too much good today because Wal-Mart stock is currently work about $46 a share. However, you have the option to buy. Lets say you had the call option and the price of Wal-Mart stock jumped to $55 per share. You could exercise your option and buy that stock at $50 per share. Woohoo. If you turned around and sold it then you would have a $500 profit.

The person buying the call option does so because he figures that the price of the stock will rise. If the price goes up enough then it is profitable to exercise the option and then sell the stock back. That is speculation. It is betting that the price will move in a certain direction in a certain amount of time. Options do not last forever. They have a limited life. If you do not exercise the option within that time (usually just a couple of months) then the option expires and you get nothing. In some respects, an option is like a roulette table. You put your money down and see what happens. Sometimes it pays off and sometimes it does not.

You may ask, why not just by the $46 Wal-Mart share at $46 rather than get an option for $50. Well, if you want to buy 100 shares of WMT, it will cost you $4600 plus fees. You may not have $4600 plus fees that you want to put out there. Right now a $50 call option on WMT that expires in June 07 will cost you $100 plus fees. You have the option to get the stock at the $50 price. You have paid for that right. If the price jumps to $55 then you can exercise and make $500 minus fees for only spending $100. Lets say you bought the 100 shares outright and the price dropped to $41. You have lost $500. If you had done the option and that happened, then you have lost your $100. If the price of Wal-Mart tanked and became worthless you would have lost $100 tops. A nice little protection there. Of course, the value of WMT stock has to go up a bit before you make much money with the option.

Another thing about options is that they can be sold back. If you bought the WMT option discussed above then it is worth more than when you bought it. Probably a few hundred. You could just sell the option and make a profit and not have to go thru the hassle of buying and selling the actual stock. The price of the stock moves and so does the value of the option. The value of the option rises or decreases faster than the stock does if you look at it in a percentage basis. A 5% gain in stock price will mean a much higher than 5% rise in the option value. The reverse is true as well.

I had said that there were two forms of options. The other is the put option. It involves a contract specifying the set price that you can sell the stock for. A put option for WMT for $50 means that you have the right to sell 100 shares of WMT stock for $50 no matter what the stock is worth. Right now, that would mean a $3.38 per share gain. Nice. Of course the put for $50 for WMT will cost $320 (the stock price at that moment was $46.62). After fees and such you would not make much money in that situation. But lets say you have bought the put option at $100. The price of the stock drops (which makes the put more valuable). You could sell now for $220 profit. That is good stuff. Like I said, when the price of the stock drops, the option becomes more valuable. Imagine the WMT stock and holding a $50 put option. Right now, you could sell $46.62 stock for $50. You could go out and buy up 100 shares and sell them and make the $220. However, if the price dropped to a flat $40 then you could make $1000. If the stock rose to $50 then you would not make money.

Ok, next up. There is buying options and then there are selling options. You can enter into the contract for either end. If you buy it then you fork over money to someone for the right to either buy or sell the stock at the agreed price. If you sell the option, then you are the someone who is getting the fee. Of course, if you do this then you need to be able to back up the contract. If the contract is exercised and it is a call then you need to come up with 100 shares of stock. If it is a put then you need to have the money to pay for the agreed price.

Options can be pure speculation. People buy them with the hope that the price of the stock will move the way they want it to. Options can also be used as an insurance policy for stock trading. In either event, they are complicated. You need to do a lot more reading and research. Go out and get some books and learn as much as you can. Also, go online and find some stock and option simulators and play with those. See what it takes to make a profit with options.

Answer 4

Stock options are basically the right to purchase some amount of stock at a specific price within a certain period of time.

You are not required to buy the stock, but you pay some money to lock in a price for some period of time.

The idea is that if the stock price goes higher than your reserved price, you can make money by buying (exercising your options) and immediately selling the stocks. Often you can do this kind of roll without actually having the cash to buy all the reserved stock.

If the price does not go up, you haven't lost as much money as you would have if you had just purchased the stock directly.

This allows you to play with larger amounts of stock - but you don't physically own any stock until you exercise the option - so you could end up paying money for nothing.

Answer 5

Your primary concern that you're probably missing is that 80% of all options expire worthless. That should tell you something, that the odds are stacked against you, that it's a wasting asset. Options are designed for hedging, not speculating, and are designed to expire worthless - that's what they're supposed to do, if the input parameters (pricing model) are correct in the Black/Scholes model. Not only do you have to guess the correct direction, as with any underlying investment, the underlying has to go beyond your target price (the strike), within a specified time before it expires worthless (expiration date). Time seems the easiest part to the beginner, so they almost always buy the front month (least amount of time), but this is what gets most option traders, and 90% of all beginning option traders lose. The markets spend two-thirds of the time going nowhere, and needs time to play out. If you have to try it, take a look at vertical spreads,where you buy the at-the-money option (strike nearest the underlying price) and sell the next strike. This way, the option sold decays faster than the one purchased, and takes care of the time and wasting premium problems simultaneously - almost, at least.

Answer 6

Options give you the right to purchase a stock at a set price. If the value of the stock goes up you can buy the stock it at a lower price or sell the option at a higher price. If the value of the stock goes down the value of the option goes down and is pretty useless unless someone thinks the stock value may go back up.

Answer 7

You want me to speculate on your options? Options are choices. If you're traveling to another State, you have several options - plane train or Greyhound Bus. If somebody stops you in the street and asks you why you're so ugly, you have the option of walking away or knocking their teeth down their throat