Understanding How Options Differ From Stocks

Options trading is among the more advanced forms of financial investment vehicles. While they can be a bit tricky to grasp, options are a great way to add some profit potential to your investment portfolio. You should be warned, however, that as you add profit potential, you also increase the risk profile of your portfolio. This is a standard rule of thumb when investing and one you should always keep in mind.

So what are options? They offer you the option to buy an asset, most commonly stocks, within a specified time frame for an already agreed upon price. They do not, however, obligate you to buy. Usually, investors use options either to increase risk or to protect against any downturns in the market.

For example, if you own a million dollars’ worth of shares in Acme Laboratories and fear stock prices could decline in the future, but you still don’t want to liquidate your holdings, you could buy “put” options to hedge against any price decline. These put options will allow you to sell stocks at a predetermined price, often the current market price.

An investor can also use options to increase risks. Let’s use a real life example. Let’s say you’re convinced that over the next few months Microsoft’s stocks will rise dramatically. As of writing this article, stocks are selling for about $40 dollars. Let us assume that you have only a thousand dollars to invest, so you could buy 25 stocks. Even if prices rise dramatically, by say $10 a share, you’d only make $250 dollars.

If you buy options, however, you can buy a call option, which will allow you to buy stocks at a predetermined price. In this case, you could by a call option that would allow you to buy Microsoft stocks for $40 dollar within six months, and you could pick up each option for only $4 dollars. If you pick up 250 options and prices rise $10 dollars, you’d make $10 dollars off each option, or $2,500 in total!

On the other hand, if you don’t exercise your option within six months, you’ll lose your thousand dollars! So, while the rewards are high, the risks are also high.

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