Stock Option Contracts

One of the riskier ways to invest in the stock market is through derivatives such as stock options. Stock options allow you to purchase or sell a set amount of shares of a stock at a set price for a set time period. The option to purchase stock at a specific price is known as a call. The option to sell stock at a specific price is known as a put. When a corporation issues options to buy its stock at a set price, it is known as a warrant. Stock options are even available based on the rise and fall of certain stock indexes.

When you purchase a call option, if the price of the stock goes up in the specified time period, you can exercise your options and buy the stock at the lower option price, then turn around and sell the stock immediately at a higher price. If you buy a put option, you're betting that the price of the stock will go down during the specified time period. Your put option allows you to sell the stock over a given time period at one set price, which may be higher than the present one, if indeed the price is dropping. You can purchase stock options from the same brokerage firms you purchase stocks from, and you should expect to pay commission fees (usually the fees are higher for purchasing stock options as compared to actual stock) just as you would with actual stocks.

What makes the profit and loss from selling stock options any different from selling actual stock? Basically, it's that by investing in stock options you only need invest the amount necessary to purchase the options rather than having to purchase the actual stock, which is quite a substantial difference.

Why are stock options so risky? Stock options involve a whole lot of guessing as to whether a stock price is going to go up or down in the near-future. You're not in for the long haul. No matter how much homework an investor does concerning a specific stock and the market as a whole, it's still very difficult to time options right so as to profit from them. This type of investing is risky even for investment professionals whose job it is to predict the twists and turns of stocks and the market, or at least try.

Another reason stock options are so risky is that an option contract is only valid for a set period. Once that period expires, you've lost the opportunity to exercise your option and, as a result, whatever you paid for the option contract. This is different than when you purchase actual stock, which is worth something, even if it goes down in price, until you sell it. It's true that the amount you need to purchase stock options is much lower than your investment when buying actual stock, so you may feel it's worth the risk to lose the lower amount. That's fine as long as you keep two things in mind. First, realize that chances are very good that you will lose your investment, and second, instead of a putting your money into a growing investment, you'll have nothing to show for what you've spent.

Stock option contracts can be quite lucrative when they do pan out because with the high risk comes high profit. However, be aware that the risk that they won't pan out is very great and you should only invest in this vehicle if you're at the right age and stage and have the risk mindset to tolerate it.

Employee stock options. Employees and executives often receive stock options in the companies they work for as an employee benefit. These types of stock options are often part of a company's retirement plan.