Introduction To Options Trading, Part 1

Summary: The study of options can expand your perceptions about the range of possibilities. Most people are familiar with two forms of investment: equity and debt. There is a third method, however, and that third method is far more interesting than the other two. Its attributes are unlike any that most people understand-and these differences can be viewed as a troubling set of problems, or as a promising set of opportunities. Let's begin with a brief review, laying the groundwork a...

The study of options can expand your perceptions about the range of possibilities. Most people are familiar with two forms of investment: equity and debt. There is a third method, however, and that third method is far more interesting than the other two. Its attributes are unlike any that most people understand-and these differences can be viewed as a troubling set of problems, or as a promising set of opportunities. Let's begin with a brief review, laying the groundwork about the two basic ways to invest. An equity investment is the purchase of ownership in a company. The best-known example of this is the purchase of stock in publicly listed companies, whose shares are sold through the stock exchanges. Each share of stock represents a portion of the total capital, or ownership, in the company. When you buy 100 shares of stock, you are in complete control over that investment. You decide how long to hold the shares and when to sell. Stocks provide you with tangible value, because they represent part ownership in the company. Owning stock entitles you to dividends if they are declared, and gives you the right to vote in elections offered to stockholders. (Some special nonvoting stock lacks this right.) If the stock rises in value, you will gain a profit. If you wish, you can keep the stock for many years, even for your whole life. Stocks, because they have tangible value, can be traded over public exchanges, or they can be used as collateral to borrow money. Example Equity for Cash: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees into your account. You receive notice that the purchase has been completed. This is an equity investment, and you are a stockholder in the corporation. The second broadly understood form is a debt investment, also called a debt instrument. This is a loan made by the investor to the company, government, or government agency, which promises to repay the loan plus interest, as a contractual obligation. The best-known form of debt instrument is the bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their operations and projects through bond issues, and investors in bonds are lenders, not stockholders. When you own a bond, you also own a tangible value, not in stock but in a contractual right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall in value based on the interest rate a bond pays compared to current rates in today's market. In the event an issuer goes broke, bondholders are usually repaid before stockholders as part of their contract, so bonds have that advantage over stocks. Example Lending Your Money: You purchase a bond currently valued at $9,700 from the U.S. government. Although you invest your funds in the same manner as a stockholder, you have become a bondholder; this does not provide any equity interest to you. You are a lender and you own a debt instrument. The third form of investing is less well known. Equity and debt contain a tangible value that we can grasp and visualize. Part ownership in a company or the contractual right for repayment are basic features of equity and debt investments. Not only are these tangible, but they have a specific lifespan as well. Stock ownership lasts as long as you continue to own the stock and cannot be canceled unless the company goes broke; a bond has a contractual repayment schedule and ending date. The third form of investing does not contain these features; it disappears-expires-within a short period of time. You might hesitate at the idea of investing money in a product that evaporates and men ceases to have any value. In fact, there is no tangible value at all. So we're talking about investing money in something with no tangible value, that will absolutely be worthless within a few months. To make this even more perplexing, imagine that the value of this intangible is certain to decline just because time passes by. To confuse the point even further, imagine that these attributes can be an advantage or a disadvantage, depending on how you decide to use these products. These are some of the features of options. Taken alone (and out of context), these attributes certainly do not make this market seem very appealing. These attributes-lack of tangible value, worthlessness in the short term, and decline in value itself-make options seem far too risky for most people. But there are good reasons for you. Not all methods of investing in options are as risky as they might seem; some are quite conservative, because the features just mentioned can work to your advantage. In whatever way you might use options, the many strategies that can be applied make options one of the more interesting avenues for investors. The more you study options, the more you realize that they are flexible; they can be used in numerous situations and to create numerous opportunities; and, most intriguing of all, they can be either exceptionally risky or downright conservative. Tip Option strategies range from high-risk to extremely conservative. The risk features on one end of the spectrum work to your advantage on the other. Options provide you with a rich variety of choices.