Sep 6th, 2010 | Written by daniel | Posted in Investing |

There are many places on the Internet where you can go to get call and put options explained, but don’t be surprised if you stumble a little bit at first if you’re trying to understand these investments. New investors can have a hard time understanding the difference between simply buying shares of stock and buying the right to buy or sell shares, as they do with call options than put options respectively.

Calls give you the right to purchase 100 shares of stock at a given price by a certain date in the future, whereas put options give you the right to sell 100 shares of a company’s stock at a certain price by a given date in the future. Investors use options to achieve what is know as leverage, meaning simply that a smaller amount of money is required to control an asset than would be required to purchase the asset outright.

Maybe an example would clarify stock options basics a little: if you bought 100 shares of stock at $100 per share it would cost you $10,000 to establish the position. Alternately, you could buy a call option giving the right to buy 100 shares of stock at 100 by a date say two months in the future, that would cost you considerably less than $10,000. Let’s say the stock is at $90 a share currently. With two months left on the option contract it is probably fairly unlikely that the stock’s price will move up over $100 a share in two months and so the cost of the option might be just several hundred dollars (naturally this amount is determined by market forces).

Should the stock increase in price as you expect and make it past $100 per share by expiration, the option will have what is known as “intrinsic value”. If the stock is at say $115 per share by expiration there will be $15 intrinsic value of associated with the option contract meaning that it will be worth $15 dollars, or $1,500 guaranteed, as the owner could exercise his right to buy the 100 shares at $100 per share and immediately resell them at $115 per share.

In his roughly sketched scenario you can see that the move required to double your money on the position, hypothetically from $90 a share to $115 a share in two months is probably fairly unlikely to occur. Of course it’s possible but it’s probably unlikely, and remember that if the stock is below $100/share when the contract expires then it will have no value at all, as the right to buy something on that date at a price that is higher than the current market price will be worth nothing.

This is the tricky part of stock options: in order for you to achieve the huge returns that one sometimes hears about when trading stock options, the underlying stock will have to make a substantial move, fairly rapidly. For most investors, being able to predict a move and then having it happen quickly enough to see a increase in the value of the options that they buy, is relatively unlikely.

This is not to say that one shouldn’t at least learn about stock options, because invested in judiciously with a small part of one’s investment capital, the leverage they provide can be a good way to diversify. Do yourself a favor though, and paper trade for a while until you get a feel for how difficult it is to profit consistently with stock options.

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• put options for $100 or less