Tax complexity itself is a kind of tax. ~Max Baucus
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Investing in options can be risky, and investors should know about these risks. Part of the risk arises from the fact that options are complicated, so here is a simplified explanation.
Generally, options fall into two categories:
* A "call" option gives you the right to BUY a specific security, currency, or index at a specific price within a fixed period of time
* A "put" option gives you the right to SELL a specific security, currency, or index at a specific price by a fixed date
An important feature of either type of option is that you do not necessarily have to own the security for which the option contract is written.
Here is an example of how the purchase of a call option works.
A customer promises to sell, through a broker-dealer, 100 shares of a stock at a certain price at any time during the next six months and ten days. If someone buys the call, he is assured that for six months and ten days he may purchase the 100 shares at the fixed price. So, if the market value of the stock rises, the buyer makes a profit by exercising the call -- that is, buying the securities at the fixed price on the contract -- and then reselling the shares at a higher price. But if the value of the shares declines, the buyer of the call will let the option expire without doing anything and lose the purchase price of the contract.
Put options work in the opposite way. A buyer of a put option contract has the right to sell 100 shares of the security to the person who sold the contract. Since the contract price is fixed, if the market price falls, the owner of the put option stands to make a profit.
Trading in options is risky, in part, because all options contracts become worthless on the date they expire. Adding to the risk is a market that can turn against an options price very quickly. An investment can even be lost before the option expires. Given all the risk of options trading and the need to watch closely price changes in the underlying security, currency, or index, this investment requires careful attention and a thorough knowledge of market trends.
Anyone who does not understand the strategies of options contracts or the principles of options trading, should carefully weigh his or her financial situation before entering the market. Do not get into options trading unless you understand it and can bear the financial risks.
Because of the risks in options trading, broker-dealers have to give investors an Options Disclosure Document (ODD) at the time or before their accounts are approved for options trading. An ODD discloses, among other things, the features of standardized option products, including their risks and purposes. Before getting into any options, you should thoroughly examine the ODD to decide whether trading in options is the right investment for you.
Broker-dealers must also provide options investors with a special disclosure document that describes the high risk involved with writing uncovered option contracts. Read this document carefully before engaging in this very risky strategy.
If you have any questions about trading in options, you may contact the Office of Consumer Affairs, Securities and Exchange Commission, Washington, D.C. 20549.
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