Financial Analysis

Options Trading Information

Understanding Options Trading

The Basics: What is an Option?

An option is a financial tool, a contract between two parties wherein the purchaser is given the right, but not the obligation, to buy or sell a set of shares at a predetermined price. The contract has an expiration date, so the purchaser of the option must exercise the option on or before a certain date. Today, most people are familiar with employee option grants or employee incentive options. These are similar to open market options in concept but typically, they can only be exercised by the employee and not sold or traded on an open market.

There are two types of options available: Call Options and Put Options.

Call Options:

With a Call Option, the purchaser has the right, not the obligaiton, to purchase the underlying shares at the predetermined price, on or before the expiration date of the contract.

Put Options:

Now that you know what a Call Option is, you can probably guess what a Put Option is. The Put Option gives the purchaser the right, but not the obligation to sell the underlying shares at the predetermined price, on or before the expiration date of the contract.

Advantages of Option Trading

Risk Management
Hedging your bets: Hedging is a security transaction that reduces the risk on an already existing investment position. An example is the purchase of a Put Option in order to offset at least partially the potential losses from owned stock. Although hedges reduce potential losses, they also tend to reduce potential profits. Because Put Options have a predetermined selling price, they allow you to hedge against a possible fall in the value of the shares you hold.

Leverage
Leverage allows you to potentially make a higher percentage of return on investment by investing in steeply discounted or low priced options. Options can enable you to make a smaller initial investment than an investment in stocks and then sell the options at a greater total margin.

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Risks of Options Trading

Loss of capital investment
Like other securities - including stocks, bonds, and mutual funds - there are no guarantees in option trading, and you must be aware that you could lose all of the principal you invest, and sometimes even more.

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