In lieu of purchasing stocks and waiting for them to appreciate, an investor may choose to purchase options. Options are financial instruments that provide their holder with the right -- and sometimes the obligation -- to buy or sell a stock at a set price. While options can act as a method of hedging existing positions, they also carry risks that are attributable to factors affecting both the option itself and the underlying stock.
Options come in two forms: put and call. A put option is an option in which the holder has the right to sell a stock at a particular price on a certain date. This option is generally held by a short seller, a person who thinks the price of a stock will fall. The opposite position is a call option, in which a person has the right to buy a stock at a certain price on a particular day.
The chief risk factor for the price of an option is the price of the stock to which the option is linked. The same risk factors that affect this stock price also affect the price of the option, as the option derives all of its value from its relationship to the stock. The stock can, in turn, be affected by a number of factors, including market sentiment and the health of the company issuing it.
In addition, the price of an option is affected by the liquidity of the market in which it is sold. Most options are sold over the counter. While some are extremely liquid -- meaning that there are enough buyers and sellers to get a "true" price for the option -- some options may have few takers, causing the price to drop.
Of course, the price of an option will change constantly until it comes due, at which point the price of the option will be directly related to the price of the stock to which it is in linked. This being the case, the "true" price of the option -- it's price upon expiration -- will become clearer as the option approaches it's final date, reducing its relative risk to investors.
- "Economics"; Roger A. Arnold; 2009
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