Stock options have been used for decades by professionals and individuals alike in order to make use of leverage to amplify positive results from an accurate forecast of the future direction of a stock. Some financial analysts would agree that putting a small portion of your investment funds-say 5%-into leveraged investments such as options or commodities makes sense, but only if you get share options explained to you and you fully understand their mechanics.
The problem is that while leverage will give you larger gains if you are correct about a movement in a stock’s price, it will also work against you if you are wrong. To be clear, going long, i.e. buying puts and calls can result in the loss of your entire investment if you are wrong.
A stock option is the right to buy 100 shares of a given stock at a certain price by a fixed date in the future. The thing to remember is that you are buying and selling this right, as opposed to shares of the underlying security. Many, many factors go into the pricing of stock options, but the bottom line is that even if you get the move you expect, it will not necessarily result in an increase in the price of the option contract that you hold. The amount of time remaining before the contract expires, and just how far away the stock prices from the price at which the contract gives you the right to buy the shares (known as the strike price), and many more things come into play.
The aspect of options that many beginners have a hard time grasping is the effect of “time decay” on an option contract. The price we pay for an option (known as the premium) is partially comprised by the value of the time remaining until the option expires (or “time value”), and that part of an option’s value is constantly dwindling, and doing so at varying rates depending on the volatility of the stock price and other things.
There’s no better advice for someone his thinking of trading options than to paper trade, most likely for months, before investing any real money. Even after you understand the game, you must get a feel for time decay and see firsthand the effects of volatility or the lack of it upon options prices. Having said all that, options can have a legitimate place in portfolio of an individual investor, as a way to make use of leverage, albeit very sparingly.
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