There are many different ways to invest your money. Investing in options is one of the more complicated ones. Options are unique investment vehicles, so it is important to learn the characteristics of options before you make any decisions about including them in your portfolio.

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Options Provide Leverage

An options buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can have a significant percentage gain from comparatively small but favorable price movements in the underlying security.

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Leverage also has downside implications for options buyers. If the stock price does not move as anticipated during the option's lifetime, the option may expire with no value. The loss can be the entire amount of the premium paid for the option. You can see a detailed example in How Do I Get Started with Call Options.

The leverage effect in options trading is a double-edged sword. It provides a cost-efficient way to establish positions with great leveraging power.

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For example, buying one call option at a premium of $5 per share will cost you $500. If the strike price is $50 and the stock rises from $50 to $60, your call option will have intrinsic value of $1000. The math works out like this: you can exercise this call option to buy 100 shares at $50 per share, or $5000. You can then sell those shares at the new market price of $60 per share, or $6000. You take in $1000 on this sale, after paying a premium of $500. In this case, a 20% increase in the underlying stock price produced a 100% profit on your premium. That’s leverage!

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There is a downside though. Whereas the losses from a decrease in the price of a stock position can potentially be made back if the market rebounds, lost option premiums are lost for good. In this way, options can still be riskier than stocks.

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Hedge Your Positions

When you own a car or a house, you usually purchase an insurance policy to cover losses from potential accidents. If you own stocks, is there a way to protect yourself from a price crash? In financial jargon, a hedge is an investment that attempts to offset potential losses from one asset with potential gains in another.

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For example, someone who owns shares of one stock might buy puts or sell calls in that u nderlying stock. A long put can hedge a position for the duration of the option, while a covered call can partially offset any losses by the amount of the premium earned. Long puts tend to be the more popular means of hedging with options, as the risk is limited to the premium paid. Selling a call generates a small amount of income in the form of a premium received but carries the risk that the call will be exercised, and you'll have to sell the position you wanted to protect.

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An investor having made a short sale of shares can buy a call option on the underlying security to protect himself from unfavorable price fluctuations. The call option effectively protects against a rise in the market price of the security sold short since it establishes the maximum price to be paid to buy back the shares.

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The Clock is Always Ticking

Options are depreciating assets. As an option approaches its expiration date, there is less time to realize a profit—or make an additional profit—before it expires. As a result, options lose value as they get closer to their expiration dates. This is known as time decay. Time decay is not a linear loss in value. It can happen slowly (in the case of longer-term options) or very quickly (short-term options). Let's take a look at this graph:

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When buying options, you lose the time value of the options as you hold them. There are no exceptions to this rule. Time decay is an important variable in understanding and trading options since it constantly pushes the price of options downward. Loss in time value accelerates as the expiration date approaches. This poses a significant risk for those who trade with short-term options or hold long-term options close to expiration.

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Let's Recap

Despite the complexities, options can be a powerful investment tool. A moderate understanding of the pros and cons can help you make a more informed investment decision. Check out this summary:

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