How Do Options Work?

A call option gives an investor the right to buy 100 shares of a particular security at a predetermined price (the strike price) before a set deadline. A put option gives an investor the right to sell 100 shares of a particular security at a predetermined strike price before a set deadline. An investor can purchase both put and call options, or can sell (or write) both put and call options. An investor who writes a put option is giving another investor the option (but not the obligation) to force the put writer to purchase a security at the strike price before a given date. An investor who writes a call option is giving another investor the option (but not the obligation) to purchase an underlying security at the strike price before a given date.

An investor who writes, or sells, a put or call option collects immediate income. That investor is hoping the option does not get exercised in which case the premium collected is all profit. If the option is exercised, the option writer is obligated to buy or sell the underlying security at the strike price. This could lead to large potential losses for the option writer.

An investor who purchases a put is seeking protection from a decrease in value of the underlying security. An investor who purchases a call is attempting to capitalize on an increase in value of the underlying security. Purchasing a call usually requires only a small investment. If the call is exercised, it may result in a large return for the investor. If the call expires without being exercised, the call purchaser suffers a 100 percent loss.

Clearly, options are complex and risky investment tools. One should not invest in these products without a thorough understanding of the risk involved. Additionally, option contracts are usually purchased to supplement a more complete investment strategy. Be sure to speak to an independent fee-only financial planner before even considering these investment products.

About the author

Lon Jefferies, CFP®, MBA
Lon Jefferies, CFP®, MBA

Lon Jefferies is an investment advisor representative with Net Worth Advisory Group, a fee-only financial planning firm in Salt Lake City, Utah. He is a Certified Financial Planner (CFP®) and a member of the National Association of Personal Financial Advisors (NAPFA). He possesses an MBA and bachelor's degrees in Finance and Marketing from the University of Utah. Lon writes articles for local magazines such as Utah CEO, Business Connect and Utah Business Magazine, and he consistently contributes articles to online magazines such as FIGuide.com and FILife.com (by The Wall Street Journal). Additionally, Lon is an expert author at EzineArticles.com. Lon has been quoted nationally in publications such as the NY Times and Investment News.

Lon can be contacted at (801) 566-0740 or lon@networthadvice.com. Learn more about Net Worth Advisory Group at http://networthadvice.com and visit Lon's blog at http://www.utahfinancialadvisor.blogspot.com.

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