After the tumultuous last ten years, prospective investors are again seeking safe ways to get back into the stock market. One of the easiest ways to get back into the market is through options.
For years, the experts have advised both the novice and the experienced investor that options were risky and not suitable for the average person. They kept this lucrative niche to themselves.
The truth is that every investment involves risk. In the past few years, we have learned that even the traditionally stable real estate market can prove risky to the unwary. As with any investment, it is important to learn how options work and how to use them correctly.
What are Options?
An option is simply a temporary contract that gives the buyer the right to buy a specific something, at a specific future date at a specific price. It does not obligate him to buy it.
For example, X is selling for $5.00 a share. You did some research, and you believe that the price of X will go up in the next three months. You want to buy 100 shares, but you don’t have the money to buy it now. So, you buy an option. You pay $10 for the right to buy 100 shares of X at $5.00 a share, three months from now.
If, three months from now, the shares have gone up, you “exercise” your option to buy them at $5.00 a share and, at the same time, sell those shares for the new price. If the shares went up $1.00, you would have made $90 – $1.00 x 100 shares minus the $10 you spent for the option.
If, at the end of the three months, you were wrong, and the shares went down $1.00, you simply allow the option to expire. You have no obligation to buy the shares.
In this case, you would have lost $10. However, if you had bought the actual stock, you would have paid $500 and lost $100.
Obviously, trading options is not for everyone. If you are ultra-conservative and unwilling to risk a little to make a lot, then options are not for you. But if a calculated risk is within your comfort zone, options can be a viable way to invest without the need to have a lot of money to start and a way to limit your losses if you are wrong.