There are many different investing tactics and strategies that brokers leverage to generate returns on the stock market.
Among these are options, which are a type of derivative security.
For the common investor, understanding exactly what are options in stocks may leave you scratching your head.
In this guide you’ll learn:
- What are options
- The two types of options (call and put)
- The risks of options trading
- And legal action that can be taken for unsuitable recommendations
So if you are ready to learn more about options, you have landed on the right page.
Let’s get started.
What are Options?
Options are a type of derivative security that gives the holder the right, but not the obligation, to buy or sell an underlying asset (such as a stock, commodity, or currency) at a specified price (known as the strike price) within a certain period of time.
For the average investor, understanding options can be complicated and intimidating. Despite this, some brokers still partake in the purchase and sale of options for their clients without properly warning them about the risks involved.
Options trading is both complex and risky and may be considered unsuitable for many investors.
When you (or your broker) buy an options contract, it gives you the right, but not the obligation, to make the purchase or sale at the agreed-upon price. This means that the price of the options contract is connected to the price of the underlying asset. If you think the price of the underlying asset will go up or down, you can buy an options contract to potentially profit from that change without actually owning the asset.
IMPORTANT: Options trading is highly speculative in nature and can carry a substantial risk of loss. As such, this type of trading is not suitable for all investors. Investors who have lost significant amounts of money in options trading have been known to sue their brokers for failing to properly inform them about the risks involved.
It is important to note that, unlike stocks, there is no actual physical “exchange” of the underlying asset when an options contract expires; rather, your broker will simply adjust your account balance accordingly (or not).
The Types of Options: Calls and Puts
There are two types of options: call options and put options.
A call option gives the options contract holder the right to buy an underlying asset at a specified price (known as the strike price) within a certain period of time while a put option gives the holder the right to sell an underlying asset at a specified price within a certain period of time.
What is a Call Option?
A call option gives the owner of the contract the right to buy an underlying asset at a certain price (known as the strike price) within a specific period of time. If the underlying asset increases in value above the strike price by the time of expiry, the option buyer will make a profit from the difference.
To purchase a call option, the buyer must pay a premium (the cost of the option). The buyer has no obligation to buy the underlying asset at any time; they can simply let the option expire. If the call option expires, the buyer will lose the money (premium) they paid for the option.
With call options, you’re ultimately betting that the price of the underlying asset will climb in value over time. Understandably, this carries a certain degree of risk and speculation.
What is a Put Option?
A put option gives the owner of the contract the right to sell an underlying asset at a certain price (the strike price) within a specific period of time. If the underlying asset decreases in value below the strike price by the time of expiry, the option seller will make a profit from this difference.
To purchase a put option, the buyer must pay a premium (the cost of the option).
If you own put options, it is in your best interest for the stock price to decrease below the strike price. In this event, whoever sold you the option must purchase shares from you at a value higher than what they are currently being traded on the market – granting you a profit and providing an insurance policy against drastic depreciation of worth.
If, instead, the market price increases rather than decreases, your shares will have gained value and all you’ll be out is the cost of the put premium. In this case it’s best to allow your option to expire.
The Risks of Options Trading
While the intent behind purchasing options is to increase the potential for profits, it’s important to understand that the potential for losses is just as real.
Options trading is highly speculative in nature and can carry a substantial risk of loss.
Some option strategies are nothing short of gambling and carry immense risk.
An example of this would be the sale of a naked (uncovered) call or put option. When a call is exercised it gives the purchaser the right to buy shares at a set price (the strike price) within a certain time period independent of whether or not the investor is currently in possession of the underlying asset.
If the option is exercised and the shares are not owned, then the seller of the option must purchase them in order to fulfill their obligation, regardless of how high the price of the underlying asset has risen.
In the worst-case scenarios, these losses can be catastrophic and wipe out an entire trading account in a single trade.
Did Your Broker Make Unsuitable Recommendations Based on Your Risk Tolerance?
Not all brokers take the time to understand their clients’ needs, preferences, financial situation and risk tolerance levels. As a result, these brokers may make unsuitable recommendations regarding investments and strategies in options trading.
If you have investment losses because your broker recommended unsuitable options trading strategies, you may have a valid claim to recover your losses. Contact an experienced investment fraud lawyer to discuss your legal rights and options.