Financial Markets For The Rest Of Us|
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
So if you are still holding your 2 FAJ contracts (from the example) on the expiration day and Ford's stock never surpasses $50, get ready to claim the $400 you spent on them (plus commission) as capital loss on your tax return.
Always remember that the option's specifications are constant. They never change through the life of the option. The variables that affect the option's intrinsic and time values are the underlying stock price and the passage of time. And since both of these variables constantly vary (at least we know that time does), the option's price is in a constant state of flux. Unless of course its strike price is so remote and its expiration so imminent that it lives a worthless existence until the expiration date arrives and puts it out of its misery.
Risk And Reward
As you read through the above sections and the examples, you probably have come to believe that options are risky instruments. They are. But as with any other investment they follow the same old risk/reward ratio. The riskier an option, the higher the potential for gain and for loss. Another way to state this would be, the riskier an option the cheaper its price. This concept is well illustrated in the time value of an option. The closer an option gets to its expiration date, the more its time value declines.
Let's get back to our example. When Ford's stock is trading at $50, FAJ options cost $2. Since this option at this point is at the money, the …
Table of Contents