Stock options trading is a form of investment that allows for the sale of the right to purchase or sell a stock within a given period of time at a set price. Options trading involves the establishment of a contract between an option buyer and an option seller. This contract specifies a time period within which and a price at which a stock may be bought or sold. Trading in options can serve as an alternative to more highly-leveraged forms of investment and can also create a valuable hedge against market uncertainty.
A stock options trading contract will take the form of either a call or a put. A call option specifies that the purchaser of the option has the right to purchase a given stock at a set price until a designated date. A put option is the reverse and specifies that the purchaser of the option has a right to sell a stock at a set price up to a set date.
Options typically have a strike price, which is the price at which they can be exercised, or acted upon. If the price of a stock does not rise to the strike price of a call option or fall to the strike price of a put option before the expiration date of the option, then no sale of stock takes place. If the price of the stock rises to the strike price for a call option, or falls below that price for a put option, the holder of the option can exercise his option, and call upon the seller of that option to either sell or purchase the specified stock at the agreed upon value.
One use for stock options trading is as a hedge against market fluctuation. Put options are often used in this fashion. A skittish investor might take out a put option on a stock that he already owns, thereby limiting his potential losses on the stock. He would be able to sell out at the strike price even if the value of the stock collapsed completely.
This type of investment may serve a more speculative function as well. An investor might purchase a put option on a stock that he does not own, if he has good reason to believe that the price of that stock will fall well below the strike price on his option. In this event, he could then purchase the stock on the open market and exercise his option to sell that stock at a profit. This form of stock options trading is similar to selling a stock short but involves somewhat less absolute risk to the investor. The investor's total liability can never exceed the price that he pays to purchase the put option, regardless of how rapidly the stock on which they purchased an option might appreciate.
Call options allow investors to realize a potentially great gain on a stock with little initial outlay. An investor can purchase a call option on a stock and only exercise that option if the value of the stock rises. This limits the investor’s exposure to risk, as his potential losses will never exceed the price of the call option that he purchases.
