- Understanding basic terms and concepts is a must before considering options.
- Options provide opportunities to trade securities at specific prices and can help monetize a stock position.
- You need to understand the risks before investing.
Options are a versatile investment tool providing the potential to generate income, hedge or help mitigate risk, and trade securities at specific prices. However, keep in mind in return for offering these opportunities, options come with a number of risks you need to understand before you invest.
Options are considered a derivative because their value is based on (derived from) the underlying investment’s price. In other words, an option’s value will fluctuate in response to changes in the underlying investment’s price.
There are two kinds of options — calls and puts — and a trader can be a buyer or seller of either.
The buyer pays the seller a premium for the right to exercise the option at the strike price until the contract’s expiration date. The seller, aka writer, on the other hand, assumes an obligation to either buy or sell (depending on the type of option involved) the underlying investment at the strike price if the buyer chooses to exercise the option.
The strike price is the stated price per share for which the underlying stock may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.
Briefly, here are the positions an option trader can assume:
Pays a premium for the right to purchase the underlying investment from the call seller at the strike price
Pays a premium for the right to sell the underlying investment to the put seller at the strike price
In return for the premium, assumes the obligation to sell the underlying investment to the call buyer at the strike price
In return for the premium, assumes the obligation to purchase the underlying investment from the put buyer at the strike price
An options contract can be cashed out in one of three ways:
- Buy or sell to “close” the position prior to expiration.
- Let the options expire.
- Exercise the right to buy or sell at the strike price prior to the option’s expiration date.
Why trade options?
If you have a complex portfolio, you may find options offer attractive benefits. For example, they may help you:
- Generate income from your current stock holdings
- Protect your stock holdings from a decline in market price
- Position yourself for big shifts in the market
- Benefit from the rise or fall of a stock’s price without actually buying or selling the underlying stock
As previously mentioned, there are significant risks associated with buying and selling options. When the value of the underlying investment moves against you, you may lose the entire amount committed to options in a relatively short period. If you decide to invest in options, you should clearly understand your rights and obligations each time you trade.
You and your Financial Advisor can work together to determine whether options are appropriate for your particular financial situation. If options are appropriate, he or she will help develop strategies for buying and selling options that fit your investment goals, time frame, and risk tolerance.
Before you implement an options strategy, you must receive a copy of the options disclosure document titled “Characteristics and Risks of Standardized Options,” which discusses specific information about the risks of buying and selling options. Be sure to ask your Financial Advisor for a copy.
Keep in mind that commissions, fees, taxes and other expenses are significant when considering any option strategy. This is especially true for multi-leg option positions.
- Understand the vocabulary of options.
- Ask your Financial Advisor for the options disclosure document.
By purchasing options, one can participate in the movement of the underlying security with a relatively small investment amount of capital (the option premium) and the potential loss is limited to the premium that was paid. However, the options purchaser may lose the entire option premium within a relatively short period of time.
Options are a very complex investment strategy with many moving parts.
Options are not appropriate for all investors.
Supporting documentation is available upon request.