Stock options are associated with various pros and cons. The primary advantage of stock options is their ability to mitigate risk. For example, an investor who owns a particular stock may buy put options to protect himself or herself against a potential stock price decline. Another advantage is that individuals may speculate on stock prices and make substantial gains without owning the stocks in question. On the other hand, stock options can magnify one's losses, which is especially true if they are used in a strictly speculative manner and/or if the practitioner uses poor strategies.
In essence, the main advantage of stock options is that they give the buyer the right, but not the obligation, to buy or sell a specific stock before a particular future date and at a predetermined price. This means that the option buyer is not contractually bound to make the particular transaction. That is, he or she can walk away from the deal if so desired. On the flip side, however, if the option holder walks away from deal, then he or she will lose the premium paid to buy the option. This is the amount paid in advance in order to get the option to buy or sell the stock, which is normally a fraction of the agreed price.
To illustrate, consider an individual who holds a stock that is currently priced at $50 US Dollars (USD). Due to personal reasons, the stockholder may wish to sell the stock within a year at the current price of $50 USD and not a cent lower. To achieve this, he or she may purchase a put option for a $5 USD premium. If the stock price plummeted below $35 USD, he or she may decide to sell the stock and get $50 USD, effectively limiting losses. Conversely, if the stock price soared to $75 USD then he or she may decide to abandon the option deal and sell the stock in the market at the new advantageous price.
An individual may make money by buying a put option of a stock he or she does not own when the price of the stock drops. Suppose one buys a put option for the same stock as above after estimating that it will plunge below $40 USD. If the price subsequently dropped to $25 USD, then the option holder may buy the stock at this price and quickly sell it at $40 USD, thus pocketing a quick $15 USD profit minus the premium cost.
Moreover, another strategy involves the use of call options. These allow individuals to position themselves advantageously in anticipation of a stock price appreciation. For instance, after analyzing a stock an individual may conclude that it is due for a rise in value. Then he or she may buy a call option that permits him or her to buy the stock at $40 USD within a given time frame. If the stock price was to subsequently rise to $70 USD then he or she may choose to buy it at $40 USD, and thus make a profit of $30 USD minus the premium paid.
In contrast to the pros, stock options can spawn great losses due to the leverage associated with these financial instruments. Basically, leverage allows an individual to hold an asset whose value is greater than his or her upfront capital. For example, a 10:100 leverage would permit an individual to gain exposure to an asset worth $100 USD for only $10 USD. Therefore, an individual engaged in such an investment is exposed to both the risks and benefits associated with the asset. In such a case, if the outcome is auspicious then the investor will reap great rewards; conversely, if the investment tanks then the losses may multiply exponentially.
Furthermore, option trading strategies considered to be very risky involve what are referred to as naked options. These are the call and put options that are sold without owning the stock in question. For example, a speculator may sell a naked call option to be exercised at the price of $50 USD. If the price subsequently spiked to $80 USD then the seller of the options will be obliged to buy the stock in the market at this price and sell it to the option buyer for $50 USD. This would produce a loss of $30 USD minus any premium collected from the buyer.