What Are Options?

Options are agreements that give you the ability to buy or sell a specific stock at a specific price (the strike price). In other words, you’ve got a locked-in price… I’ll get into the specifics in a minute.

Options are derivatives, which means that their values are tied to those of other securities…in this case, stocks. So when a company’s stock price changes, so will the prices of the company’s options.

Just like with stocks, you can buy and sell options through your online broker. It’s important to keep in mind, though, that your broker may charge more to buy or sell options than they would for stocks — you’ll have to ask to find out.

Unlike stocks, however, options aren’t necessarily put out there on the market by the company…often, they’re put out by third parties like investment banks.

What Kind of Options Are Out There?

There are basically two different kinds of options out there — call options and put options. Call options give the owner the right to buy shares of a stock they believe will increase in value, but at a lower price.

If you think that Apple (AAPL: NASDAQ) is going to see $200 again, you could buy a call option with a strike price of $142, and own the right to buy Apple at $142 after it hits $200 — that’s a nice locked in gain!

If your hunch was wrong and Apple slides to $110, you can choose not to buy the shares at $142, and only be out what you paid for the option.

Put options give you the right to sell shares of a stock you believe will decrease in value, but in this case, at a higher price. Going back to the same example…

If you think Apple’s set up for a fall, you could buy a put option with that $142 strike price, and own the right to sell Apple shares at $142 after it falls.

Remember, though, options give you the right, not the obligation to buy or sell a stock at a specific price… You’re not required to exercise the option.

If a stock doesn’t end up doing what you expected, you can still just let your options expire and only be out the price you paid for the options themselves.

Who Uses Options?

These days, everybody uses options — and for good reason… Options are a great way to hedge, or insure, your investments against downside. If you like Apple for a long-term play, but aren’t so sure about its short-term risks, you can buy AAPL stock along side put options for the company. That way, if the stock does take a hit, you can offset your losses on the stock with the money you make on the options.

If you end up not needing the option play, you’re still only out the price of the option. Just consider that cost an insurance premium for your portfolio.

In the big leagues of investing, you can bet that plenty of portfolio managers use options to hedge against losses, but don’t think that only financial companies use hedging!

Southwest Airlines has long been a darling stock in an industry that’s seen crippling losses. How’d they do it? Southwest saved their skin by investing in derivatives that were tied to oil prices. Southwest limited their exposure to soaring jet fuel prices while other airlines felt the bite.

It’s Not a Bad Option

When it comes to maximizing your portfolio’s profitability, using options is a pretty good…umm…option. Investing in options shouldn’t be taken lightly of course — making the wrong options plays can open you up to some big downsides.

Cheers,

Jonas Elmerraji
April 7, 2008

P.S.: There is another technique that works like options but is even safer. In fact, many of the richest people in the world grew their fortunes using this secret technique.

Investing in Options was originally featured in the Penny Sleuth.