What is an Option? Stock Options Explained

by Adam on April 10, 2016

The internet has changed so many things in recent years, not least in the financial space. No longer do we have to visit a branch for most of our banking needs – even telephone banking is becoming less popular than simply getting what we need to do online, and through apps on our smart phones.

business IPOSimilarly, investing in the markets is more accessible than ever too. I set up this site, Magical Penny, in part in response to this huge change. Anyone can get started investing from the comfort of their own home, and even when you’re out and about with a finger swipe on a smart phone.

The 21st century investor has a lot of choice, too. There’s long-term investing strategies in stocks and shares ISAs and pensions, and there’s shorter term strategies, where investors trade in the markets with hopes of growing their pennies more quickly through actively buying and selling shares and derivatives like options.

What is an Option?

An option is a binding contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.

For example, imagine you found a great house but you didn’t have the money straight away to buy. You could talk to the owner, and pay him some money to keep the house available to you for a couple of months and agree a price of £120,000 for when you may wish to buy it.

The money you would give him at the start would be the ‘option’ as you have kept the option to purchase the house at a later date for a certain price. The important thing about an option is it gives you the right to buy something but not an obligation to buy it at the end of the agreed period.

The same idea works with stock options. You can purchase an option to buy a particular stock for a certain price at any time over the set time period. If the price of the stock goes up, you have the option to buy at the original cheaper price. If you exercise the option, you can buy the stock at the cheaper price, and then immediately sell the stock at the current higher market rate. If your profit on the sale is more than the price you paid to buy the option, then you’ve made money! If the price of the stock is less than your option price, you don’t have to exercise the option, and the option simply expires. In that case, all you’ve lost is the money you paid for the option as you never actually held the stock itself.

The attractive thing about options is you have the potential to make more money than if you had simply bought the stock to start with. The challenging thing about short-term investing is it takes skill and good timing in order to navigate and understand the ever-fluctuating prices.

You also should consider keeping up with the latest news and market analysis to help you trade. One site where you can do this is Banc De Binary. With longer term investing, you don’t need to worry as much about the ups and downs of the market because you are investing to participate in the general upwards trend of the stock market over time.

The internet is a powerful thing and has made investing and trading more accessible than ever before. But with great access comes a great responsibility to do proper research and ensure you invest responsibly and understand the amount of risk you are taking on with your investing. Good luck in growing your pennies!

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