Stock Options & Other Orders

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Dec 20, 2006
Before making any investment decisions involving stocks, it is essential to know what type of orders can be made and how to read certain pertinent information that will be displayed to you when researching various companies’ stock information.


First and foremost it is important to know and understand some basic yet important terminology. When receiving a stock quote, there are generally three important things that you should want to know right away. The first is the current value of the stock. This is established as the last price that the stock was sold for. When you hear that a stock is trading at $25 per share, that means that the last trade of the stock between a buyer and a seller was for $25.


The next two important things that you should know and understand is the “bid” and “ask” price. The bid price represents the highest price that someone is willing to pay for the stock at any given moment, and the ask price represents the lowest price that a seller is willing to sell the stock for.


Something very important to note is anytime the bid price is higher than the current value or “last” price, than someone is willing to pay more than the stock is currently worth, which will raise the value of the stock to the latest purchase price, if indeed the person bidding was successful in buying shares.


Also if the bid price is far below the current value or “last” price, that means that the market is not in high demand of that particular company’s stock and if the stock is sold below current market value, than the stock price will decrease with it, as the value or stock price only represents the last price that the stock was sold for.


On the flipside though, if the bid price is far above the current market value and the ask is above also, and the two meet somewhere above current market value, then the stock price will increase accordingly to what the last stock sold for.


When placing orders to purchase stock, there are many options that a person can make in deciding what type of order to make, and I’ll be discussing the ones that I feel are important for you to know.


Market Order


A market order is the most common type of order in the market place. A market order doesn’t request that the stocks be bought or sold at a certain price. It just asks that the transaction take place at whatever the going rate is in the market place.


When someone makes a market order request, they are not concerned with buying or selling at a certain price and are generally comfortable with whatever the going rate is at the time of the request. For example, if someone makes a market request to buy some of General Motor’s stock, and the going price is $29, then that is the price that they are going to pay.


Buy Limit Order


A buy limit order is an order that request that the designated stock be purchased at a certain price or below. For example, if Wal-Mart stock is trading at $49, and an investor wants some, but doesn’t think its worth more than $47, thus not wanting to pay more than $47 for it, he can put in a buy limit order of $47. When the stock price dip down to $47 or below, the stock will be purchased for the going price, as long as it is less than $47.


A buy limit order is a very good way to protect yourself from paying more than a certain price for a stock, especially if you’ve noticed a high level of volatility in the price of the stock and want to capitalize and buy it.


For example, if you noticed that Exxon Mobil’s stock price constantly fluctuates from $65 to $67 on a daily basis, and you wanted to buy some at the low point, then a buy limit order at $65 would buy the stock for you when it was again available at $65.


Sell Limit Order


A sell limit order is very similar to a buy limit order, but in this case as the name indicates, it involves selling a stock instead of buying one. A sell limit order is a request to sell a currently owned stock at or above a certain price. This sell limit price is usually higher than the current market price.


For example, lets use help from the example above, and say that after buying the Exxon Mobil stock for $65, your wanted to sell it as soon as the price went back up to $67, as you noticed it’s been doing for the last couple of weeks in your observations. In this case you would place a sell limit order of $67, and as soon as the going rate was $67 again, your stock would be sold, thus making you a quick profit.


A sell limit order is a good way to sell a stock at a certain price without having to watch the market and waiting until the market was paying a certain amount for the stock. With a sell limit order, you can just place it, and whenever the stock price goes back up, your shares would automatically sell.


Options Trading Basics


Options can be very risky if used the wrong way. They can also be very rewarding if used correctly, similar to any investment, but it is much more serious with options as you could potentially loose more money than you can dream of.


Options are a very good investment if you are the one buying them, and potentially suicide if you are the one selling them. For the record, unless you are filthy rich, do not sell any options (you’ll see why shortly) that require you to buy or sell a stock at a certain price, especially if it’s not covered.


On the positive side, purchasing the right kind of option can be like having insurance on your stock in case the price declines. Also, a certain option can be purchased on a stock that you don’t own, and if the stock price rapidly increases, your option gives you the right to buy the stock at the low price that’s agreed to on your option.


Let’s take a look at some of the option choices out there, and which ones to stay away from. If you go against what I’m about tell you, you may need more than this book to gain wealth, as you may end up in a whole that is way too deep to climb out of.


Call Options


A call option can be your best friend, but if used the wrong way, it can quickly turn into the greatest enemy that you ever had. A call option gives the owner of it the right to purchase (call) a specific stock at a certain price (strike price), no matter what the real value of it is.


For example, if I own a call option on Nike stock with a strike price of $30, and the stock rises to $100, the person who sold me the call would be forced to sell me the stock for $30, even though it is now worth $100 per share. Obviously this would give me a quick $70 per share profit, without having much initial risk, as I only paid pennies on the dollar for the option to buy, instead of buying the stock outright.


On the other hand, the person who sold me the call option would be in a deep world of mess. If he owned enough shares of the stock to satisfy my order than he could just give me his shares, but if not, then he would have to buy the shares at the current market price of $100 per share, and then turn around and sell them to me for only $30 (my strike price) per share.


This could obviously put him in a horrible situation, and one that I don’t ever want any of my readers to be in, because it could turn out much worse than this. What if the stock price went up to $2,000 a share? The person who sold me the option would have to go out and buy enough shares to satisfy my request at the market price of $2,000 per share and then sell them to me at $30 (my strike price) and loose a ton of money in the process.


If the person was covered (owned the shares that he sold me the option on), then instead of being forced to buy the shares at market price, he would loose out on what could’ve been a magnificent profit, since he would have to sell me his shares at only $30, instead of being able to sell them at the current market price of $2,000 a share.


Like I said, a call option could be your best friend if used properly, so it is important that you understand how to use one. For example, let’s imagine that you’ve been watching a certain company’s stock and you believe it is getting ready for a strong upturn, but you’re not sure.


Instead of buying 1,000 shares of the company’s stock, which would be an expensive investment and a potential large risk, you could buy 10 options (each option gives you the option to purchase 100 shares) that would that would give you the right to buy 1,000 shares at a specified price, so you can still profit from the stock’s price gain (if it actually does increases) without having to actually own the shares at the time of the increase.


Put Options


Similar to a call option, if purchased, a put option could also be your best friend, and used like an insurance policy for a stock that you currently own to protect yourself against a downturn. A put option gives the owner of a stock the right to sell (put) a stock to the seller of the put option at a specified price, no matter of what the actual stock price is. For example, let’s say I buy 100 shares of Wal-Mart stock at $50 per share. If for some reason the stock price declined to $0, I would be at a loss of $5,000, unless I bought some “insurance” (a put option).


If in this scenario, I purchased a put option with a strike price (right to sell price) of $50 immediately after I bought the stock, and then the stock price declined to $0, I would still be able to sell my shares to the seller of the put option for $50 per share, thus my only loss would be the price I paid for the “insurance” (put option).


In this scenario the seller of the put option would be the one out of $5,000, minus the small revenue he received from selling me the put option, which would probably only be around $500, thus giving him a net loss of $4500, and giving me a loss of only $500. This is good for me as I could’ve been at a loss of $5,000 instead of just $500.


As you can tell, buying a put option for protection is a great idea, while selling a put option to someone else can be a natural disaster waiting to happen. The thought of being forced to buy a stock for $50 that’s no longer worth anything should show you the seriousness and potential dangers of selling put options.


Like with any investment, options can be good or bad depending on the level of knowledge of the investor. Also, one last note for selling call options, they are particularly extra risky because there’s no limit to how high a stock price can go, thus giving the seller of the call an infinite amount of risk.


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