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If you are like us, then the first time you heard of a stock option, you might have had trouble wrapping your mind around it.
After all, options are so much more complex than stocks. They have strike prices, expiration dates, calls and puts.
We’re here to help you demystify the concept of stock options and understand what they are.
Stock Options Definition
Stock options give someone the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date.
Stock Options Example
Why would someone want to own an option? Well, one of the key reasons is that they are so cheap compared to stocks.
For example, imagine Apple stock is currently selling for $110. Now imagine I have the right to buy Apple stock in, say, one week for $100.
If you ask yourself how much that right is worth, see what your mind comes up with. How valuable would it be to you to be able to buy Apple stock at $100 if the current price of Apple is 10 dollars higher?
If the answer in your mind is “around $10”, then you’re on the right track. Being able to buy a stock at $10 less at a future date might be worth about $10.
That example gives a good example of why options cost less than stocks. You’re not paying the full price for the stock. That means they come with more leverage.
So let’s pick back up with our example. Imagine that you paid $10 for this option to buy Apple stock for $100 in one week from now. The stock for Apple was at a price of $110 when you bought it, but imagine that one week later, the price of Apple stock is $115.
At this point, the value of your option is closer to $15, which represents a 50% gain on your investment. Compare that to owning the stock, where the same change in price results in roughly a 4.5% gain on your investment.
That demonstrates the power of options.
More Details About Stock Options
From the example above, the $100 price is referred to as the “strike price”. And the “one week away” is referred to as the expiration.
Also, our example gave you the option to buy the stock at a future date, which is referred to as a call option. The option to sell it at a future date is a put option.
One more thing to be aware of is that in our example, we said the option might be worth around $10. It typically is going to be more than that. The reason is that you typically have to pay at least some amount of premium to buy the option. You can think of it like paying for the right to use options as an investing vehicle.
How to Make Money with Options
You can take an options trading course to learn more about options.
You can also subscribe to an options alert service.
We like the one offered by Mindful Trader. He has an options alert service that is helpful for people who are just getting started with options. The options trades are ones that are easy to follow and not as complex as other ones out there.