Stock Option Basics
What Are Stock Options?
By John Ondercin
Nov 11, 2006 - 8:27:00 PM

The purchase of an option gives you the right but not the obligation to either buy or sell a specified number of a financial instrument at a specified price within a specified time period. A Call Option gives you the right, but not the obligation, to BUY (go 'Long' the market). A Put Option gives you the right, but not the obligation, to SELL ('Sell Short' the market).

Why Trade Stock Options?
Options were created to reduce risk. The principle of trading/using options to reduce risk is simple. Options allow you to control an asset (a stock) at only a fraction of its purchase price. The less money you put at risk, the lower the potential hazard to your financial well being. But remember, when you utilize what we've already taught you about using Stop Losses' (ISL) when entering the market (either 'Long' or 'Short'), there will be NO need to worry about losing too much money on a trade (a maximum of 8% of the value of the stock). The manner in which you can use options though can provide opportunities for tremendous profits.

So what are we saying here? Something that was supposed to reduce risk offers opportunities for tremendous profits? Higher profits always come at the expense of higher risks, don't they? Not necessarily! The secret lies in the definition of risk and in the use of leverage.

The use of options is a little like buying lottery tickets. You bet only a few dollars for the opportunity of winning a large amount of money. You know that your chances of winning the lottery are very small, so you bet only small amounts of money at the time. If you win, however, the payoff can be huge. This is what options are all about...risking a small amount and controlling hundreds of thousands, perhaps millions worth of assets.

The most common example of using options is the case of writing a small check to hold a house you may wish to buy. In this example, you demonstrate your willingness to buy the property by committing a relatively small amount of money to the realtor. In most cases, the money isn't really at risk because it will be refunded to you if you decide not to buy the house or release the property before the agreed upon deadline. Although buying and selling stock options is not quite as customer friendly, the idea is the same.