Stock Option Picks

Written by Elise Allen
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Stock options are tools investors can utilize to increase leverage. With a just a couple of hundred dollars, a person can control several thousand dollars worth of stock. An option contract is one which states the holder of the contract can buy or sell a 100 share lot of the underlying company on a specific date. There are two types of option contracts: calls and puts. A call option is one which gives the contract owner the right to buy 100 shares of the underlying stock at a predetermined price. A put contract is the opposite of a call contract. Puts give the contract holder the right to sell the underlying stock at a specified price. Basically, if you expect a stock's price to go higher you will want a "call," if you expect a stock to fall you will want a "put."

There are two basic components of an option contract which influence their pricing: the strike price and expiration date. The strike price is that which the underlying security can be bought or sold. The expiration date is when the contract can be executed or will expire. For example, A General Electric January 30 call states the contract holder can buy 100 shares of General Electric at $30/share on the third Saturday in January. Sounds a bit confusing, but when you get more experience with options it becomes second nature.

The reason why the strike price and expiration date influence an option contract's price is due to the time factor. Built into the price of every option contract is what is called a "time premium." The further from the expiration date, the more time premium you will pay. As expiration approaches and the stock is away from the strike price, the time premium will start to erode. Finally, if on the expiration day the stock is below the strike price (in the case of a call contract) it will expire worthless and the investor loses all of the investment.

Choosing Stock Options

The time focused nature of an option contract forces an investor to focus on a stock which will make a significant move in a short period of time. This requires an options trader to have extensive knowledge of technical analysis. Technical analysis is most often used to identify short term moves. Technical analysis involves understanding the relationship between price and volume and other various indicators. Relative strength, which measures a stock's price strength versus the S&P 500 or other key index, is a good indicator of a weak or strong stock. Stochastics are other tools which some investors utilize to identify "overbought" or "oversold" conditions. In my opinion, price and volume is the best indicator of a stock's future direction.

As stated above, the first step to choosing an option contract is to decide which direction you believe the stock price will go. Second, you must decide which strike price to choose. Finally, determine which expiration date you believe gives you the best opportunity for success. Remember, the further from the expiration date, the more time premium will be built into the option's price. If the underlying security's price does not move as expiration approaches, the value of the option contract will decline. Trading in options is risky and is not suitable for everyone.

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