stock options are a unique investment
when used effectively they can be
extremely powerful and can help generate
great returns
but if used unwisely they can be very
risky in future videos i will go further
into how to use stock options
and how they can complement a portfolio
but for now let's just take a look at
what stock options are
and how money is made so what is an
option
an option is an agreement that gives you
the right or the option
but not the obligation to buy or sell
shares of a company
by a certain date and for a certain
price to better understand the
fundamentals of options
let's look at an actual example i know
microsoft has options on it so let's
start there
here's what an options quote looks like
as you can see
there are two types of options calls and
puts
you benefit from owning a call if the
stock moves higher and you benefit from
owning a put
if the stock moves lower let's look
closer at a call option
just remember puts act in a similar
fashion just in the opposite direction
let's break down the details of this
call option
okay this date this is called the
expiration date
just a moment ago when i said you had
the option to buy the stock by a certain
date
this is that date as you can see here
microsoft has options
with many different expiration dates one
thing to keep in mind
see these prices the further the
expiration date the more expensive the
option
that's called time value another factor
affecting the price of options
is the price of the stock as compared to
the target price see this
this is the target price much like the
expiration date
there are many choices for target prices
and as you may be able to logic out
the closer the target price to the
current price the more you will pay for
the option
once again this makes sense microsoft is
currently trading at 85.23
if you wanted the option to buy it at
87.50
it would cost you more than if you
wanted the option to buy at 95.
why well based on where the stock is now
there's a greater likelihood that it
will reach
87.50 as compared to it reaching 95.
this brings us to another key point
notice how our brokerage firm was kind
enough to color these in for us
well they do that because these calls
here are below the current price
that's called being in the money and
these are called out of the money
and imagine microsoft was trading at
exactly 85
instead of 85.23 they would call that
at the money now let's look at the
actual option price
this price here 2.57 cents
this is quoted per share and as a common
rule
an option is a representation of 100
shares
so if you buy one option you would
multiply that price by a hundred
so this option would cost you two
hundred and fifty seven dollars
now i'm sure you have already begun to
piece together how you can make money
with options
but let's walk through it anyways let's
imagine bought this one option
you paid 257 for this stock option
which means you now have the option to
buy 100 shares at 87.50
per share microsoft is currently trading
at 85.23
which means this option is 2.27
out of the money so let's fast forward
let's imagine that microsoft stock has
risen to 95 dollars per share
this means that you are now seven
dollars and fifty cents in the money
let's imagine your option is currently
trading at eight dollars and ten cents
which as we know is worth eight hundred
and ten dollars so now you have a few
choices
choice one sell the option you just log
into your brokerage account and sell the
option in the same manner that you
bought it
you will receive the eight hundred and
ten dollars not including any
commissions
congrats the option cost you 257 dollars
and you just sold it for 810 that's a
return of 215
now choice two let's imagine that the
reason you bought this option is because
you really wanted to own microsoft stock
perhaps you just didn't have the cash at
the time and you didn't want the price
to rise on you
well choice 2 is called exercising the
option well since your option is was for
87.50
and you've elected to exercise when you
exercise you now buy the 100 shares
which is the same as one option
at 87.50 per share your brokerage will
take the 8750
and will give you the one hundred shares
once they hit your account you will see
the value of those options
will be ninety five hundred choice three
keep holding the option perhaps you
believe that microsoft share price will
continue to rise
in that case you might elect to continue
to hold the option
now for the downside let's pretend we
elected choice number three we decide
we're going to hold the option
well much to our dismay the stock begins
to fall
and before we know it the stock is
trading at eighty six dollars and fifty
cents
now let's assumptions expire next week
now the listed price of the option is
listed as five cents
when we multiply that by a hundred it's
five dollars
in this case the option is fairly
worthless because
it's out of the money and there's very
little time value
well we decide we're going to wait a
week there's only a week left we've come
this far
why stop now over the next week the
stock begins to rally once again
climbing all the way back to 87.40
and on the day of expiration you see it
getting very close to the 87.50
strike price and you intently watch the
stock all day waiting for it to get
above
that 87.50 target price
also called the strike price and much to
our disappointment
the market closes and your stock never
goes back above 87.50
it got close but it never got there what
happens now
nothing your option is expired and your
original investment
of 257 dollars is gone in other words
it expired worthless so that is how
options work
as you can see they are high risk high
reward types of investment
now i personally think that options are
a great tool when used correctly
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