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Stock Option Trading

By: J.A.J Aaronson - Updated: 26 Jun 2010 | comments*Discuss
 
Options Stock Trading Underlying Asset

As an investor it is likely that you will have a portfolio that includes a variety of different investment types. The majority of investors’ portfolios now seem to include securities such as bonds or stocks, but there is another valuable tool which is often overlooked: the option.

For the slightly more advanced investor, options can provide a valuable opportunity to adjust your portfolio to a particular situation very quickly. Options are, by their very nature, a speculative tool, and as such they are not suitable for all investors. Furthermore, they are a very high-risk venture; if you are considering trading in options you should ensure that you are well versed before you begin.

Explanation

The concept of an option can, perhaps, be best explained with an analogy. Imagine that you wanted to buy a plot of land, but you didn’t have the money just yet. The owner agreed to give you the option of buying the land at a cost of £50,000 on or before a certain date (say, six months in the future), and this is written into a binding contract. For this option, you pay the buyer £1,000. During the six months, you do some investigation and you find that you would be able to get planning permission for the site which would raise the value of the land to £500,000. In this case you would buy the land, having made a profit of £449,000. Alternatively, you may have found that the land was waterlogged and impossible to build on; in this case you would not buy the land, and would therefore lose your £1,000.

An option gives the buyer the right to trade in a particular financial product (known as the underlying asset) before or on a certain date, and at a certain price. An option is a binding contract, but the buyer is not obligated to buy the underlying asset; they can simply let the expiry date of the option pass and take no action.

There are two types of options, the ‘call’ and the ‘put’. A call option gives the holder the right to sell an underlying asset, in the hope that its value will rise during the option’s term. Conversely, a put option allows the holder to sell an underlying asset, in the hope that its value will fall. Investors who buy options are known as ‘holders’, while those who sell them are known as ‘writers’; holders are under no obligation to buy or sell an asset, while writers are obligated to stick to the terms of the option if the holder so wishes.

Reasons

There are a variety of reasons for trading options. The biggest investors in the world trade options as they are a highly speculative form of investment; speculation is a very high-risk venture and, as a result, is where the biggest money is made and lost. Essentially, speculating with options is equivalent to gambling on the value of an underlying asset. The great attraction of these investment types, however, is that you can make money even if the market falls. It should be stressed, however, that this type of investment can lead to enormous losses if the market doesn’t go your way.

Finally, it is worth noting the availability of employee stock options. A number of large companies offer share options to their employees in order to retain them. This represents an option agreement between an employee and the company whose stocks are the underlying asset. Employee stock options rarely yield huge profits, but they can present a nice dividend in the future.

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