Column 6
The Versatile Option
April 24, 2002The Versatile Option
Options can be used in many ways, and really are versatile investment tools.
Some uses for options:
- To enable you to buy stock at a lower price
- To enable you to sell stock at a higher price
- To bet on the size and direction of a change in the price of
- One stock
- One segment of the market
- The entire market
- To protect an investment against a large loss
- To provide additional income, similar to receiving dividends
- To lock in an investment profit
Options
can be used in a conservative manner, but most people believe options are
only for speculators. As the weeks pass and you read these columns
you will see how options can be used by almost every investor. When
using options in your investment portfolio, you must decide if you are interested
in taking a conservative approach (highly recommended) or taking a more
aggressive approach (I do not recommend this). In playing it relatively
safely, or in taking a chance to earn additional money. The measure
of risk vs. reward is a constant concern for options traders. I hope
to convince you to use options in a conservative manner. I believe
the profit opportunities available from the conservative use of options
are sufficient so that it is not necessary for you to add risk to your investments.
Options are not for everyone, and there is no guaranteed profit when using options. Both options and stocks are investments with potential for reward, but losses can occur, no matter how conservative your strategy. By being aware of the risks at all times, you will make better decisions. The profit potential is substantial when options are part of your portfolio.
Let’s review the most basic definitions:
If you buy an option, you are betting the price of a specified stock changes in the direction you want (for calls, the direction is up; for puts the direction is down). The risk of an investment of this type is limited, because you cannot lose more than you paid for the call option. Most options you would consider buying are relatively low priced, again limiting your loss. Nevertheless, this is a somewhat risky strategy because the option buyer frequently loses most or all of his investment. To offset those losses, the option buyer has the opportunity to turn a small amount of money into a much larger amount. That is the lure of buying options and why many people love that strategy. Making a large profit from a small investment involves the use of leverage, and next week we will take a closer look at the concept of leverage.
To learn about our book, click here .
Options are not for everyone, and there is no guaranteed profit when using options. Both options and stocks are investments with potential for reward, but losses can occur, no matter how conservative your strategy. By being aware of the risks at all times, you will make better decisions. The profit potential is substantial when options are part of your portfolio.
Let’s review the most basic definitions:
- Call option – a contract giving the owner the right to buy 100 shares of a specified stock (underlying) at a specified price (strike price) for a specified period of time (until expiration). The choice is the hands of the owner of the call. He/she is not required to actually buy the stock, but he has the right to do so
- Put option – The same idea as a call, but the owner has the right is to sell the underlying stock.
If you buy an option, you are betting the price of a specified stock changes in the direction you want (for calls, the direction is up; for puts the direction is down). The risk of an investment of this type is limited, because you cannot lose more than you paid for the call option. Most options you would consider buying are relatively low priced, again limiting your loss. Nevertheless, this is a somewhat risky strategy because the option buyer frequently loses most or all of his investment. To offset those losses, the option buyer has the opportunity to turn a small amount of money into a much larger amount. That is the lure of buying options and why many people love that strategy. Making a large profit from a small investment involves the use of leverage, and next week we will take a closer look at the concept of leverage.
To learn about our book, click here .
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