Can I buy an option that lasts for two or three years?

This is most certainly true. Most optionable stocks have longer term option contracts, some of which do not expire until December 2011.

In reference to a starting point an investor always needs to reflect on their trading objectives, or views as this will always form the basis of their trading strategy. Keeping in mind that both call and put options are available, this gives investors a significant amount of flexibility to trade directionally, increase diversification and manage risk.

Call options give buyers (sometimes called holders) the right to buy the underlying security at a specified price and put options give buyers the right to sell the underlying security at a specified price. The price of an option is often referred to as the premium. All things being equal, the price of the call will rise if the stock price rises and the price of the put will rise as the price of the stock falls.

Leverage is one of the major attractions for investing in options. Not only does each contract represent 1000 shares, but each contract can be purchased for a fraction of the price of the underlying security. This translates into an investor being able to gain the same exposure to a stock for a fraction of the cost, or alternatively, gain a significantly higher exposure for the same cost. Thus when trading directionally, an investor is able to gain exposure on the upside buying calls and on the downside buying puts.

Leverage also allows investors to increase their diversification and manage risk. As less capital is required, investors have more funds available to purchase options across securities and sectors increasing the diversification and reducing the risk of their portfolio.

For an existing portfolio of stocks buying put options can provide a cheap and simple method for managing risk. An investor can buy put options covering individual stocks in their portfolio or even buy put options on the index to cover their whole stock portfolio. This concept is called hedging.

One of the most important concepts for investors that are new to options is that they have a limited life and that their time to expiration is directly related to option price. All things being equal, as an option approaches expiration the value of that option will decrease. This relationship is particularly important for buyers of options as time is always working against them.

Paul Le Roy, Trading & Operations Manager, OptionsXpress

This information is provided by an Authorised Representative of optionsXpress Australia Pty Ltd AFSL 246743. In providing this information, optionsXpress Australia Pty Limited has not taken into account the investment objective, financial situation and specific needs of any particular person. Trading involves risk. Before making an investment decisions you should seek advice from a professional advisor.