Option Contracts

• A single stock option reflects the value of 100 shares of real "underlying" stock. Options fall into two categories, "calls" and "puts," and these generally move opposite one another. A call option usually rises in value when the underlying stock rises in value. This is because the option contract lets its holder buy shares of the underlying at a fixed price, regardless of the actual price. As the gap between the stock's actual price and the contract's fixed price grows, the call option becomes more valuable. A put option instead lets the buyer sell shares at a fixed price, thus it becomes more valuable as a stock declines in price.
  
  

Leverage

• Leverage refers to the sensitivity of a financial product to market changes. Stock options are highly leveraged because they react to the swings of 100 shares of stock per option, but they cost much less than the outright purchase of 100 shares. Thus the percentage returns are dramatic. It is possible, though risky, to earn the same net profit as you would trading thousands of shares of stock, but do so with just a few option contracts that cost a fraction of the price.
  
  

Examples

• Consider the stock for the Intel Corporation. On April 20, 2011, this stock was up nearly 7 percent during mid-day trading. The most-traded call option for this stock allowed its buyers to buy the stock at $21 per share, which was approximately $0.15 below the market value of the stock during mid-day, making it quite valuable. This stock option contract rose in value by 400 percent compared to the day before. On a strictly intraday basis, the lowest price for this contract during the first few hours of April 20 was $17 when Intel traded at $20.95. The option rose later that same day to $38 when Intel hit $21.23. Thus, if you had bought at the low and sold at the high, you would have doubled your money in only three hours. Similarly, you could have bought a put option for $7 that morning and had it rise to $19 in about 30 minutes as the stock endured an initial decline before rising the rest of the day.
  
  

Warning

• The profit potential in intraday option trading is appealing to many novice traders, but it is a high-stakes game that can easily wipe out a brokerage account due to the excessive volatility. Additionally, you cannot day trade stock options unless you meet the strict criteria by the Financial Industry Regulatory Authority, which requires at least $25,000 in capital in the brokerage account for stock-related trades, including options. If you day trade options in a smaller account, brokers must suspend your trading privileges altogether.