Money Matters Wealth Tip #55 – Options 101
Some markets are too exotic for mainstream investors. They may contain risks that are too high, require too much capital or depend on technical knowledge the average investor does not possess.
Yet with knowledge most investors can find ways to participate profitably and manage risk. Typically such markets are not understood because the terminology is scary.
The options market in one such market. It is a market that is not broadly understood and those investors who have heard of it see options as highly risky and dangerous. Lack of understanding create fear and rightly so.
As a general rule to investing no one should invest unless they follow this:
No one should ever invest in anything unless they become educated as to the markets risks, opportunities, rules of trading and terminology.
The Options Market
Many believe the options market is highly speculative. This can be true but if you understand the options market it has many different strategies. It can also be conservative depending on your strategy. Options can be used in many different ways. You can use options to hedge your positions or as insurance to protect your gains.
You can overcome your thoughts that options are risky and speculative by gaining knowledge. Once you have learned about the option market you can make informed decisions and use this as a tool to grow you net worth.
An Educated Investor
An educated investor is one that helps markets thrive. When investors understand markets they calculate their risk and reap the rewards. Smart investors have profit targets and understand when to cut their losses and get out. Learning about a market opens up a whole new world. When you become knowledgeable about a particular investment it becomes less scary and the profit potential is opened up to you.
Rejecting an investment market before learning about it is an opportunity missed. If after you learn about the market you chose to not use as an investment vehicle then you have made an informed decision.
Puts and Calls
The most common types of options are puts and calls. A call is the purchase of an option that based upon your purchase you believe the stock will go up. A put is the opposite. This is where you believe the stock will go down.
Puts and calls all have an underlying stock attached to it. 1 put or call controls 100 shares of stock. There are definite expiration dates. Loses are generally limited to the amount you pay for the option.
Most puts and calls expire worthless. The strike price is the price the option holder has agreed to buy or sell the stock.
A call option is the right to buy shares of an underlying stock at the strike price before expiration date.
A put option is the right to sell shares at the strike price by the expiration date.
Example Call Option
Shares of Disney are selling for $100. If you were to buy a call option for a $100 strike price expiring in 30 days. One may pay a premium of $2 per share to own that right. The cost of 1 option which controls 100 shares would cost $200. If you were to buy 100 shares at $100 your cost would be $10,000. If shares were to rise by $2 per share your 100 shares would now be worth $10,200. On the other hand the option price could rise by $1 so you option would be worth $300.
The return in the option going from $200 to $300 is 50%, while your return if you owned the shares is 2%.
Do you see the power of options? The returns are accelerated. This assumes you sell the option before it becomes worthless at expiration.
Example Put Option
Sticking with our Disney example. Buy a put option at a $100 strike price for $1, cost to you $100. If the shares go down then the price of the put goes up. At $100 per share for 100 shares total cost $10,000. If the shares go down by $2 to $98 then you will lose $200. The put option would go up in value by $1 again increase in value by $100 actually going up 100%.
So while holding the shares you lose $200 if you purchased a put option and sold it before expiration you would have made $100.
Power of options
The examples given are just that examples. This what could happen but as we know things do not always work out perfect. Trading options can be profitable but you need to be careful.
I would paper trade these until you get comfortable. Learn the language and expand you investing potential.
Many believe that options are more risky than owning the stock. I do not. The earning potential is greater and in many cases quicker.
Yes you can loss and in fact you will. None of us have a crystal ball. Remember cut your losses short and let your winners run. Do not go for homeruns. Take the singles and doubles.
If this was helpful let me know in the comments below.
If you enjoyed this Money Matters Wealth Tip the series can be found HERE.
Other articles of interest:
10 Easy Steps to Creating a Budget that will put you on the path to Financial Independence
How to get out of Debt: Three popular Plans
4 Payoff Credit Card Debt Strategies
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