Option use is the best when the volatility is at high levels and the
stop loss point on a particular stock is about the same price as the
cost of an option. Also time spreads are also the highest as volatility
increases the option premiums. "Call options" is a contract giving the
holder the right to buy 100 shares of the underlying stock within a
certain time frame. The concept is like leasing a car. You have the
right to buy this car at the end of the term but instead of paying the
whole premium up front like in buying options, you pay it to the
financing company by monthly installments. Your lease expires at the end
of the term and just like an option, you may exercise it, (buy the car
or buy the stock), or just let it expire, (give back the car or do
nothing on the options side.) It is that simple.
"Put options" are the opposite as it gives you the right to sell 100
shares of the underlying stock also within a certain time frame and at a
certain price. If the stock falls below this price, (called "strike
price"), you will be guaranteed to sell at your strike price. Obviously
the shorter the time you buy for protection, the cheaper you pay. A one
month premium is less expensive than two months and so on.
Theoretically, if you want downside protection for an infinite time
period, then the premium will equal the price of the stock.
Both these definitions are for buying puts and calls as the buyer has
the right to exercise or sell their puts at any time prior to the
options expiration, (the period one has purchased for.) Please remember
that a buyer has the right while a seller is obligated as this is a very
important distinction.
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