Stock option contracts allow holders the right to buy -- for call options -- and sell -- for put options -- the underlying shares at specified strike prices on or before set expiration dates. Option holders can exercise their rights only at the strike prices. Stock options usually expire on the third Friday of each contract month. Options are worthless after expiration. Investors often use options as insurance policies against losses.
The options exchanges facilitate the writing and buying of option contracts. The premium is the market price of an option contract. Option writers or sellers must deliver shares if call option holders exercise their rights to buy. Similarly, writers must buy shares if put option holders exercise their rights to sell. An option holder will only exercise an in-the-money option. This means that the strike price is higher -- for put options -- or lower -- for call options -- than the market price. The value of each contract is the premium multiplied by 100, which is the usual number of underlying shares.
Call and put options hedge against losses in short and long positions, respectively. For example, if you bought a stock at $15, a put option with a strike price of $15 could protect you against losses because it would increase in value if the stock price falls. Similarly, if you sold short a stock at $20, a call option with a strike price of $20 could protect against a sharp rally because you could exercise the call and buy back the stock at $20. Options allow you to speculate on the direction of the stock market. You would buy call options if you expect a rally, put options if you expect a correction. The risk is that if prices move in the opposite direction, you could lose your entire investment in the option itself if you buy one. And, in some cases in which you sell an option and have to cover it with stocks that have moved wildly against you, your loss potential could be unlimited.
The profit or loss on a stock option position is equal to 100 multiplied by the difference between the stock price and the strike price -- for an exercised option -- or 100 multiplied by the change in the premium. For example, a call option's premium could increase from 50 to 60 cents if the underlying stock price increases from $10 to $11. The resulting profit would be 10 cents multiplied by 100, or $10, per contract. If you owned the option, you would earn a 20 percent return -- 10 cents divided by 50 cents, expressed as a percentage -- while owning the stock itself would yield only a 10 percent return -- $1 divided by $10, expressed as a percentage. The risk is that if the market price falls below the strike price, the call option could become worthless very quickly, while the stock position would retain some value and could rise in the future.
Most options expire in less than nine months. For a longer time horizon and additional flexibility, you could buy Long-Term Equity Anticipation Securities, or LEAPS, which stay active for up to three years. Since options generally trade in lower volumes than shares, you should place only limit orders to ensure that the order fills are within acceptable price ranges.
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