Money Management Guide

Maybe you understand the basics of buying and selling stock, but what you have heard about stock options has you thinking that they are way too dangerous for you to dabble in. It is true that options involve more risk than simply buying and selling stock. It is also true that you only want to be involved in options if you fully understand them. But some investment advisers advocate setting aside a small portion of your investment funds-maybe 5%, or less-for riskier investments like stock options. The idea is that the overall performance of your portfolio might be enhanced in the long run with a few well-chosen leveraged investments.

Leverage is simply having a given amount of money control more of an investment or asset it would normally be able to buy. A home mortgage is the most common form of leverage, where 20%, 10% or even less down payment is required to “own” the home, with payments made to a financial institution who essentially lends you the difference between what you put down and what the price of the home is. If you put 20% down on a $200,000 home, and then saw the value rise to $300,000 in 10 years say, it would be quite clear to you how the power of that $40,000 down payment was amplified into an $300,000 equity gain (not counting mortgage payments of course) in 10 years.

There is not normally a lender involved when you purchase stock options (buying stock on margin is analogous to our mortgage example). But with stock options you can use a relatively small amount of money, the premium amount, to control 100 shares of stock that could be worth many thousands of dollars. Without delving into the specifics of options trading, let’s just say that having the right to buy stock at a certain price at a certain date in the future is a way to use leverage to achieve spectacular gains. Of course if the move you anticipate does not occur, the right to buy those shares at a higher price than where the stock might be trading at that date might be worth nothing at all. This can result in losing all the money you have in an options position.

The idea with buying and selling put and call options is that the rewards are much greater for being right about the direction a stock will move than they would be if you had simply bought the stock. A 10% or 20% gain over a six-month period on a stock you purchase could be equivalent to doubling your money or better if you had bought options instead, depending on the specifics of strike price and expiration date. Again, these are not positions to take with a big percentage of your investment capital. But sometimes taking a small amount of money and putting it towards a trade without having to close other positions to free up a lot of money to buy the stock can be a way of participating that you wouldn’t otherwise have.

Again the standard disclaimer: options are risky and even with a good stock options explanation you should consult a financial professional before you invest in them with real money.