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The purchaser of an option has the right, but not
the obligation, to buy or sell a particular stock at a stated price
(the strike price) at any time prior to the option's
expiration date. There are two types of options:
Call Options
The right to buy a stock at a specified price
over a specified term.
Put Options
The right to sell a stock at a specified price
over a specified term.
Strike Price - this is the price that you
can buy (call) or sell (put) the underlying stock.
Exercise - to exercise an option means
that you are taking up the contract, and buying (calls) or selling
(puts) the underlying stock at the strike price. You should only
exercise an option if it is in the money.
Risk - options can be an inappropriate
investment for some people. This is due to the fact that you stand a
chance of loosing your whole investment. However it is also quite
common to make 100-200% returns within a month with options. All you
own is a contract that will expire, options can last from less than
a month to up to two years. The longer the term the higher the
price.
Premiums - premium is the price you pay
for an option. Option premiums for any individual stock option are
determined by a competitive bid between buyers and sellers. Premiums
are valued by three factors; 1. the option's strike price, this is
the intrinsic value 2. the time remaining before the option expires,
this is the time value 3. the volatility of the market.
Intrinsic Value - intrinsic value exists
only when an option is in the money. Call options are in the
money when the stock price is higher than the strike price. Put
options are in the money when the stock price is lower than the
strike price. You can purchase in the money or out of the money
options. The in the money options will command larger
premiums. Essentially if a stock is about to go up or down 40-50% over the
term of the option it is better to get options further out of the
money, as they will cost less and have much higher return. If the
shares are only going to go up or down 10% then you want an option
closer to in the money.
Time Value - time value is the amount
buyers are willing to pay for an option based on the possibility
that it will, at some point, become profitable to exercise. The
probability that an option will become profitable to exercise
lessens considerably as the expiration date gets closer.
Volatility - if a stock price is more
volatile it will generate higher price movements that can make
options profitable.
What to do With an Option - there are
three choices you have with options, you can 1. sell the option back
to the market 2. exercise the option and enter the stock market 3.
let the option expire.
Advantages - you can make a higher return
with a smaller investment.
Disadvantages - you can loose your entire
investment.
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