Have you ever looked at a stock to buy and were really excited about it, but hesitated because you thought it also could just as easily go down? If this happens to you, consider using an option instead of buying or shorting the stock.
One of the most basic option strategies utilizes a call or put.
Substitute an option to potentially lower cost and risk while still maintaining the profit potential.
A call (up) has the right to be long from a specific price and a put (down) has the right to be short from a specific price.
Instead of purchasing or selling short shares, an option can be used with many advantages.
The number one advantage is that when you buy an option, your risk is limited to the premium paid. No matter what happens to the underlying stock, the option risk is limited to that original cost.
Each option controls 100 shares of the stock for much less than the shares outright.
Two Simple Rules to Follow
Here are a couple of rules to follow when choosing the right option:
1. Buy more time than you need. Options are for limited duration and time is an important asset in the price. The more time you buy the more expensive the option will be. Generally, it is advisable to purchase at least three months of time or more to minimize time decay.
2. Choose an option that will behave much like the stock. To do so, the in the money option with a delta near 75% is a good substitution. The delta is the mathematical percentage that the option moves compared to the stock.
Additional Things to Consider
The choices of call or put, expiration month, and in-the-money strike can all add up to a winning position with less risk and cost than the stock itself.
When the option has gained value simply offset it and exit by selling. Though you have the right to the stock shares, the option sale is the preferred way to close out the position.
Buying or shorting a stock can be a big investment. To minimize the amount of capital you have a risk consider using an option versus buying the out right stock.