John Lansing

The Life Cycle of Trading Options

by John Lansing   04/04/09

WHAT CAN HAPPEN TO A LONG OPTION POSITION?

When you buy an option, the underlying stock can do one of three things.

1. It can go in the direction you believe it is going to go. (A long call option becomes profitable when the stock trades up to, and through, the strike price; a long put option becomes profitable when the stock drops down through the strike price.) When the stock crosses the strike price in your favor, that makes the trade in-the-money. The deeper the in-the-money the option, the higher your potential returns.

2. It can trade in the opposite direction. If this happens, you may lose the full value of your investment if the stock doesn't change direction during the life of your trade.

3. The stock enters a holding pattern. If the stock trades relatively flat, your option could expire worthless, thanks to decreasing value due to time loss. (This is for options that are trading out-of-the-money; if the option is in-the-money, there is value by closing the option position or by exercising it.)

In some instances, the option may lose value even if the underlying stock is going in the direction you hoped it would. This is because the value of the time loss exceeds any increase in the value of the option due to changing stock prices.

This is where stocks and options diverge significantly. Where stocks will still hold some value in neutral and declining markets -- barring any dramatic events specific to the individual company -- options can lose much or all of their value.