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Investing in financial markets requires an understanding of the various investment choices available to individual investors such as mutual funds, bonds, stocks, exchange-traded funds and stock options. Each of these choices works in a unique manner and has unique risks and benefits.
To help the investor get started, this section highlights key differences between two popular choices: investing in stocks and trading stock options.
Stocks represent ownership in a public company. An investor that holds a company's stock is called a stockholder or shareholder. A shareholder receives voting rights in important company matters and a share of the dividends (if any) paid by the company. An stock option holder receives the choice to buy or sell (depending on option type) a stock, but none of the benefits of stock ownership.
Options expire at a date in the future called the expiration date after which point the investor no longer has the choice to buy or sell. Stocks do not expire.
Both stocks and options can be sold to another investor. Options can be sold prior to or on expiration date.
A stock option provides the choice (but not the obligation) to buy or sell a specific stock at a specific price called the strike price. The choice to exercise must be made on or before the expiration date.
There are two types of options: calls and puts. An investor holding a call option gets the right to buy a specific amount of a certain stock at a specific price on or before as certain date. Conversely, an investor holding a put option gets the right to sell stock. The stock that can be purchased or sold is called the underlying.
Stock options are standardized which means that an overseeing regulatory body decides which options should be made available to investors for trading. The investor can invest in any of the available options.
Market Chameleon shows the options available for a given underlying stock on a page called the Option Chain.
Stock Prices are based primarily on market forces, company fundamentals such as the company's earnings outlook, success of products, etc. Stock option prices are based to a large degree on the price of the underlying stock, time to expiration and other factors. Securities whose value is based in large part on the value of another security are part of a class of investments known as derivatives. Another example of a derivative is stock futures.
One significant advantage of holding options over stock is that an option holder can earn significant profits if the stock goes up or down without bearing the cost of trading the stock itself. However, if the stock does not move in the desired direction, the investor can lose the entire purchase cost of the option.
Let’s assume that an investor wishes to invest in the stocks of XYZ Company. He/she has $1,000 and the value of the stock is $100 per share. For the investment of $1000, the investor can purchase 10 shares of stock. On the other hand, the call options with a strike price of $100 of the same company are valued at $200 per 100 shares, i.e., $2 per option. This means that the investor can buy five options contracts for $1000 and control 500 shares instead of just 10 shares.
Options have an expiration date so lets assume that the options expire in 6 months. Now there are two possible situations:
a) The value of the underlying security, i.e. the shares of XYZ Company, rises significantly to $120 and the investor decides to buy the 500 shares at the agreed price $100/share. Now the investor has a $20 per share unrealized gain.
b) During the contract period, the share price drops significantly, and the investor chooses to let the options expire because he/she is under no obligation to go through with the purchase. The Investor loses the $1,000 paid to purchase the stock options.
This is an example of a call option; a put option works in the opposite direction.