Are Options Worth the Risk?

01/08/2016 10:22 am EST

Focus: OPTIONS

Options trading can be an ideal way to increase your net worth if done correctly, though there is significant risk involved. So, for the benefit of newbies still unsure if options are worth this level of risk, Sean Bryant, at Investopedia.com, offers an introduction.

In the world of investing, there are a lot of securities in which you can invest your money: stocks, bonds, commodities, mutual funds, futures, options, and more. Most investors stick with mutual funds. Of course, there is a fee, but it takes all the management worries away. Many will invest in stocks and bonds to try to capture larger gains. And some will invest in options. Options trading can be an excellent way to increase your net worth if you do it right.

What Are Options?

Options are contracts that give you the right, but not the obligation, to buy or sell a security. In essence, you purchase the option to buy (or sell) the security.

For example, let’s suppose you want to buy 100,000 shares of XYZ stock for $5 per share. But either you don’t have the money at the moment to buy that much or you are nervous that the price may drop. So you purchase the option to buy at $5 per share for $5,000. Now you can legally buy XYZ stock for $5 per share, no matter what the share price does; the contract lasts about a month.

Suppose a few days later, XYZ Company releases better than expected earnings and says that they have invented a machine that will solve world hunger. Overnight the stock shoots from $5 per share to $50 per share. You exercise your option and you spend $500,000 to buy $5,000,000 worth of the stock. You turn around and sell it for a $4,495,000 profit ($5 million - $500,000 - $5,000).

Now let’s suppose the opposite happens. XYZ Company declares bankruptcy and goes under. The stock drops from $5 per share to $0. You can let your option expire worthless and you are only out the $5,000.

That’s the easy part. The confusing part is that there are more options than just the option to buy. You can take four positions when trading options. To read the entire article click here…

By Sean Bryant, Contributor, Investopedia.com

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