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Buying Options: What Every Investor Needs to Know


Have you ever wondered about how to get started investing in options? Options trading has been increasing in popularity over the past few years. Television shows like Fast Money and Options Action devote a significant amount of time discussing option strategies for investors. Investors and traders are attracted to the low cost, high return potential of options trading. Today I would like to take a look at a few of the more popular strategies for buying options.

Types of Options

Call Options

Call options give an investor the right to buy shares at an agreed upon price. Investors that buy calls are not obligated to ever exercise the option. Call options can be owned for as short as a few days or long as a year. Investors that purchase call options are bullish on a particular stock or ETF.

Put Options

Put options are just like call options except they give investors the right to sell shares of a stock. Bearish investors buy put options so that they can benefit from a stock that they expect to decline. Watching the activity in put options is a great way of judging when investor sentiment is turning bearish.

LEAPs

LEAPs stands for Long Term Equity Anticipation Securities. LEAPs are long term options that last a year and longer. Long term investors use these contracts to buy long term call and put options.

The Advantages of Purchasing Options

Buying call options are cheaper than buying shares of stock.

Call options allow investors to buy shares of a company for a much cheaper price than buying the actual shares themselves. For example, say you wanted to buy 100 shares of Best Buy at $35. Your total cost would be $3,500 plus the brokerage fee. So, you would pay a total of $3,510.

A cheaper option would be to buy call options. You could buy one January 2011 call option for $3.90. Your total cost would be $390 (100 shares x $3.90) plus the brokerage fee. You would only pay $400 which would save you over $3,110. If shares of Best Buy are higher than $39 by January 2011, you would exercise the option and make a profit. If not then you can just let the option expire. Your total risk is only $400. For a $400 investment you could control 100 shares of Best Buy.

Buying put options can limit your downside risk.

Buying a put option is a great way for investors to limit their downside risk.

Let’s say you already owned 100 shares of Apple and the stock is currently at $170. You are afraid that the stock is going to decline but don’t want to sell your shares. You could protect your profits by buying a put option with a strike price of $165. By doing this, you have unlimited profit potential and have limited your losses.

This strategy is known as a protective put strategy. If the stock drops substantially, you can always exercise your put option. If shares rise you can do nothing and just let the option expire. Put investors can also employ a married put strategy. A married put strategy is when an investor buys shares of a stock and buys a put option on the same shares at the exact same times. The stock and option are considered married since they were both purchased at the same time.

If used properly, options can cost less, limit risk, and have the potential for higher returns.

Next week we will take a look at strategies for selling options.

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Comments

  1. Great introduction. I’m just beginning to look at Options, so this is right up my alley. Thanks.

  2. I traded stocks back on 2000, I was doing very well them the 911 thing happened, since then I have not trade any more, but I wan to get back in the game.

    lots of great information on this blog.

    thanks