Stock options are a relatively new kind of trading instrument, used for Investment Protection, insuring your stock portfolio against market risk.
Stock options are quite complicated and they are suitable only for experienced investors, nonetheless, there some simple tips that will help you understand the basics of their pricing structure.
What Is An Option
An option contract on stocks, is the right to buy or sell 100 shares of any given stock (that has options offered on it), in the future, and at a fixed stock price. Stock options come in two kinds of contracts, Calls and Puts, a Call option grants its buyer the right to BUY the 100 shares at any time during the option contract term, whereas a Put option grants its buyer the right to SELL these 100 shares, always at a predetermined, fixed price.
Stock options were introduced in the early 70’s as a hedging tool in the financial derivatives’ world. Their purpose was to allow investors and traders a form of Investment Protection. Ultimately, the purpose of their introduction was to make the financial world, and global trade more stable!
Stock options are used by stock investors, but there also options on foreign currencies used by all major exporters in the industrialized countries. Even large, professional farmers in the US use options to secure favourable prices, for selling their products.
Other commodity options are crude oil options, and these are used by all the big oil companies such as BP, Exxon Mobil etc, so that even though crude oil may rise from $70 to $170, they still keep buying at $70 for years, because their option contracts do have a fixed delivery price of $70. Even though they will be selling us their fuel products, at a price, adjusted for crude oil being $170!
Investment Protection – Stock Options For Small Investors
To an investor who wants to protect his stock portfolio against a possible short-lived down turn in the markets, there are single stock and stock-index options available. These are Put options, and they become profitable when the markets fall.
Below we can see the profit/loss diagram of a Put stock option, the cost of this option is a premium of $200. This premium is fixed too, and is all the option costs. This stock option has a strike price of $40, and also $40 is the current price of the stock the Put option is based on. But this doesn’t have to be so, you can choose any strike price from a wide range of strike prices.
Put stock option profit/loss diagram – It costs $200 to buy, and it acts as insurance in case the stock drops in value. The option’s term can be anything from few months to as long as 3 years. So unlike actual stocks, options have an expiry date! – Much like other insurance products you maybe familiar with:
By buying a put option (long Put) the investor has downside Investment Protection on the stock he has already bought. This helps cut almost all his losses in case this stock goes down and never fully recovers, like in the 1990s tech bubble. And this is the reason private insurance companies and private pension funds can guarantee your retirement, and the growth of your money.
On the other hand, the traditional 401K industry in America does not use such hedging techniques, or at least it didn’t do so in recent years. As a result many 401K account holders saw their retirement savings, shrink by as much as 40% because of stocks and mutual funds in that 401K account that fell and never recovered fully.
Generally, stock options and put options in particular are a great way to protect your stock portfolio in cases where a down turn is expected, but you still want to keep the stocks at the same time. So even in the worst case scenario, where the stocks never fully recover, you will not lose any money, making this a fantastic strategy for Investment Protection!
If you are looking to become involved in options trading and get the exact same trades as the professionals use, check out the renting shares or renting stocks strategies and get on the same side as the winners.
Stock Market Investing Strategies and Market Speculation by..
Scott Smith
Investing The Stock Market © 2008 – 2010
Previous Post >>> Stock Market Arbitrage – The Facts
Hi Scott, nice post.
You’re right, using Put Stock Options with a Stock Position or Portfolio can give the trader piece of mind, as it is a great way to protect the value of the Stock.
I like to use them with the Covered Call strategy in certain market environments.
They can be perceived to be a little complicated, but options can be used to real advantage if used with a good understanding.
Sound advice there. It's crucial in any kind of options trading to get some education before risking your money. Paper trading (using a real trading platform but with a simulated-money account) is a great way to get some practice. Are there platforms available for doing this?