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A major difference in trading options vs. stocks is that an option can make you a huge amount of money compared to a small movement in stock price.
A stock is a piece of a company that you can buy or sell in the stock market. As an owner, you have voting rights and can collect any dividend paid by the stock.
Options contracts, on the other hand, give you the right to buy or sell shares of stock at a certain price by a certain date.
If you decide to exercise your option, you will either buy or sell shares of the underlying stock. You'll pay or receive the price defined in the options contract.
That depends on whether you buy a call or a put option. Calls give you the right to buy the underlying stock. Puts give you the right to sell the underlying stock, whether you own it or not. Call options will move higher and lower in price with their underlying stock. Puts will move in the opposite direction.
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While options prices usually do not move dollar for dollar with their stock price, the good news is that due to their much lower purchase price, the percentage moves can be huge. That is what makes them so attractive.
When an Options Strategy Is Good
Both stocks and options are quoted in dollars per share or per contract. However, in trading options, you must also decide on the exercise price, called the strike price, and the expiration date.
If the underlying stock of a call option trades below the strike price, the option is called "out of the money." A put option is called "out of the money" if the stock is above the strike price. That is because exercising the option at that time will result in a loss.
When the underlying stock trades above the strike price for calls or below the strike price for puts, the option is called "in the money." If you exercise the option at that time, you make a profit.
The more an option is out of the money, the lower its price.
Since options expire, their value declines as they get closer to their expiration date. The combination of strike price and expiration date is an important consideration.
How Options Trading Can Double Your Money
Because options expire, long-term investors should stick with buying stocks as their primary investment vehicle. We will talk about using options to supplement your returns a little later.
For shorter-term investors, options can provide tremendous bang for your buck due to their low prices. For example, a stock can rally from $45 per share to $50 per share in a few weeks. But a call option on that stock can move from $1 per contract to $2 per contract at the same time. The stock gained 11.1%, but the option gained 100%.
And since options prices are low, the dollar risk is low, too. When you buy options, you cannot lose more than you paid for the option, no matter how far the underlying stock moves in the wrong direction.
Investors can also combine stocks and options in several ways. One of the top two strategies is hedging a stock you already own against market decline. A put option on that stock will go up in value as the stock goes down. It acts as a partial insurance policy in volatile market times.
The second is selling call options on stocks you already own. These are called "covered calls," and you can earn income on the option without much risk at all.
Options can enhance your returns, hedge your holdings, or make you money outright.
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