An insurance policy for your portfolio.
Although options may not be appropriate for all investors, they are one of the most flexible investment choices.
Options can play a role in your portfolio, even if you are a conservative investor. For example, the power of options lies in their flexibility. They enable you to adapt or adjust your position according to any market situation.
An option can allow you to sell stock you own at a price you predetermine within a specific time period, regardless of how low it goes. Or, you could earn a premium on your stock by selling a right to buy your stock at a price you set. Even if your stock never reach your predetermined price, you would still earn the premium.
You can think of an option as insurance for your portfolio. Options can protect you against a steep market decline. Let’s say you are concerned the price of your stock may drop. You can purchase options to give you the right to sell that stock at a price you set within a specified time period, regardless of how low the price drops.
Before you begin trading options, you should know what exactly is a stock option and understand the two basic types of option contracts.
What is an option?
An option is a contract written by a seller that gives a buyer the right — but not the obligation — to buy (a call option) or to sell (a put option) a particular asset, such as a piece of property, or stock or some other security. In return for granting the option, the seller collects a payment (premium) from the buyer.
If you sell an option, the premium is the amount you receive. The premium isn’t fixed and changes constantly – so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow.
Options contracts are either “calls” or “puts,” and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.
When you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. A call option is in-the-money if the current market value of the stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price.
When you buy a put, you have the right to sell the stock on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it.
If an option is not in-the-money at expiration, the option is assumed to be worthless.
There are three key features of investing with options: 1) leverage, 2) protection, and 3) volatility trading.
Leverage:
If you don’t want to commit your capital in an uncertain market, you can purchase the right to buy a stock at a certain price (a premium) at a fraction of their value.
