The basics of options

Most, if not all, investors can build great wealth via longterm investing in the stock market — without ever buying or selling stock options. But it’s still worth knowing a bit about options. Imagine wanting to invest in Iditarod Express (ticker: MUSHH), known for its slogan, “When it absolutely has to get to a remote corner of Alaska in a few weeks.” You can buy some shares the usual way — or you can use options.

There are two main kinds of options contracts: “calls” and “puts.” Owning a call gives you the right to buy a certain number of shares, at a specific price, within a certain period (typically a few months). Owning a put gives you the right to sell a certain number of shares at a specific price within a certain period.

Imagine that shares of Iditarod Express are trading at $50 per share. If you expect the shares to rise in value soon, you could buy 100 shares for $5,000. Or you might buy, say, $6 “October $55” call options. In that case, $600 would get you the right to buy 100 shares at $55 each until the calls expire in October. If the shares rise to, say, $65 before the options expire, you can exercise the options and buy 100 shares for $5,500. You can then keep them — or sell them at their going price, for $6,500. Since you paid $600 for the options, your profit is $400, less any commissions and taxes.

If those MUSHH shares fell in value, though, or didn’t rise much, your calls would expire worthless and your $600 would be entirely lost. You essentially wagered that the stock would top $61 per share — $55 plus $6 — by the October expiration date. Options are enticing because they let you amplify gains or hedge against losses. But they also often expire worthless, losing all the money you paid for them.

Option-trading strategies range from somewhat conservative to risky. Learn much more before trading in options — or just avoid them altogether.