A stock option is derivative financial instrument that gives the holder of the option the right to buy some particular stock at the predetermined strike price till the end of the option (or at the end, depending on the type of the option).
It is a good instrument for the buyer that wants to control risk exposure and at the same time earn maximum from stock movements. For example, if investor buys a call stock option and pays $1 for it when stock’s price on exchange is $5 and the strike price is $5, after one month stock price rises to 10$ and investor earns $4 ($10 last stock price on exchange - $5 strike price - $1 price paid for stock option = $4). And the entire amount that investor put at risk was initial investment equal to $1. But that is only theoretically. In practice most of the times that initial investment (in this example $1) turns in to zero.
Stock options are very risky investments and should be used by investors only in very specific cases or for defensive hedging strategies. If investor is using stock options for speculating purposes, exposure to stock option investments should be not more than 3%-5% in a portfolio for very experienced investors. Stock options may lose all the value in few days, especially if they are ‘out of cash’ type.
Options can be made not only for stocks but also for any other securities. Call options increases in value when price of the object increases but value of put options increases when price of object decreases.
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