Many investors are scared off by options. There's a mound of paperwork to fill out with many pages telling you how you can "lose everything" if your trade goes wrong. And, they're not that easy to understand – there's a lot of jargon out there like "put," "call," and "strike" that aren't intuitive to most people.
But the truth is options are a versatile investment tool. They can be used to protect your portfolio, and they can help you pick up huge profits. Plus, options offer strictly limited risk. If an option trade goes the wrong way, you won't lose more than your initial investment plus commissions.
For this tutorial on options, we'll stick with the more common stock option as our example.
So what are options?
Options are a type of investment that gives you the right to buy or sell a security at a certain price for a specified amount of time.
Story Continues Below
In other words, options give you the right to bet on the direction of a stock, but you are limited to that bet for a certain period – usually from 1 to 9 months for standard options. LEAPS, which stands for Long Term Anticipation Securities, are longer-term option that last from 9 months to 3 years.
Here's an example for a standard stock option:
Say you believe that the slowdown in the housing market will send Lennar's stock into the gutter. Earnings for the stock come out in June, and you're betting the market is going to be very surprised at how dismal their quarter was.
In this case, you'd look to buy "put options" on Lennar. Put options are a bet that the underlying stock price will go down. Call options, on the other hand, bet that the underlying security's price will go up.
A smart move is to give yourself a little time to make sure that you're right about the trade, but not too much time that it is cost-prohibitive for you to make the trade. Options are referred to as "wasting assets" because they lose value the longer you hold onto them.
Also, the longer the time before the option expires, the more premium you will pay. Premium is the price you pay for the option. An expensive option has a high premium; a cheap one has a low premium. Option premiums are determined by the market, just like stocks. And options are traded on an exchange, just like stocks.
One other important fact, options expire on the third Friday of the month. So, if Lennar's earnings are scheduled to be announced in the last week of June, you'd want to buy an option that expires the next month.
So, you'd probably want to buy a July put option on Lennar, giving you enough time for the stock to fall and for your position to be profitable. In options language, when a position is profitable, it's called "in the money." Conversely, an unprofitable trade is "out of the money," and a break-even trade is "at the money."
What price would you pay for the option so that it's "in the money" when you sell it? Say Lennar's stock is currently trading for around $60. You think that it will get whacked by about 10% when its earnings news hits the market. That means you think the stock will fall to $50. So, you buy the Lennar 50 July Call option.
In this example, $50 is your strike price, the price at which your option would let you buy or sell the underlying stock.
Not many people are with you on that bet, so the option is cheap, around $1. You can only buy options in lots of 100. So, you'd pay $100 per option contract. If you buy 5 contracts, your premium would be $500. That $500 controls 500 shares of stock. Think about it. If you were to buy 500 shares of Lennar stock at $60, you'd spend $30,000 to control the same amount of shares using options – that's leverage!
Another advantage to investing in options is that you can never lose more than you invest in an option. If the trade doesn't go your way, you only lose the amount you paid for the option and any commissions related to the trade. But if the trade goes your way, the leverage in options allows you to multiply your profits with just a small move in the underlying stock price.
Those are the basic concepts for investing in options. See our other articles on strategies for trading options.
Editor's note:
Diversify your portfolio in foreign bond funds – More Info Here
Sir John Templeton warns of market, housing crash – Read More Here
Protect yourself from the coming real estate crash . . . read this! Click Here
