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Options: Time-sensitive investments

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  Options: Time-sensitive investments
What options are and how to get started investing in them.

Upon hearing the phrase "stock options," most people tend to think of high-rolling executives who can now cash in on the incipient riches that induced them to join their company several years ago.

But there is another kind of option that you can get in on -- the publicly traded kind. This type of option involves the investor's belief about whether a given stock or index of stocks will rise or fall in value within a set time period.

You can buy options to buy stocks (known as "calls") or options to sell them ("puts"). A call is a contract to buy a set amount of stock at a set price for a set time period, regardless of what the market does in the interim. A put is a contract to sell a set amount of stock. Accordingly, buyers of calls hope that the stock will increase substantially before the option expires, so that they can then buy and quickly resell the amount of stock specified in the contract, or merely be paid the difference in the stock price when they exercise the option.

Conversely, buyers of puts are betting that the price of the stock will fall before the option expires, thus enabling them to sell it at a price higher than its current market value and reap an instant profit.

All options are contracts for what is known as a "wasting asset" -- that is, if the buyer of an option does nothing, the option to buy or sell stock expires and the option becomes worthless. In an investment world where many professionals subscribe to the buy-and-hold philosophy of long-term investing, it is no wonder that these same professionals get palpitations from the daily gyrations of the market. If they are speculating in options, they can't be passive; the clock on options is always ticking.

Within the time frame in the options contract -- often a period of several months -- investors must evaluate the best time to exercise the options or face losing the money they spent to buy them. In some instances, the least costly alternative is to do nothing, as exercising the option would cost more than letting it expire. Nevertheless, holding options forces investors to keep a close eye on the market each day, searching for the best opportunity to buy or sell.

But what about those of us who aren't professional investors? What are some approaches to options that are appropriate for you as an individual investor who has other things to do besides obsess over the market? Here are a couple:

  • Get your feet wet by buying options, and avoid selling them. The most you'll lose by buying options will be the price of the options contract itself, which is known as the premium. If you think prices will increase, buy calls. If you believe they'll nosedive, buy puts. Until you're seasoned -- and this seasoning can include some bitter tastes of the market -- avoid selling options. When you sell the stock, you could actually be expected to deliver, possibly at a price far below what you can buy it for according to your contract. Or you could be expected to buy it at prices far higher than its current market value. Either way, these investments -- known as uncovered options, because they're not backed by underlying shares -- can be highly leveraged, and thus can lose you your shirt.
  • Use puts as portfolio insurance. Buying puts can protect your portfolio against market drops. For example, if you own a substantial amount of a given stock, puts can reserve the right to sell this stock at a given price as a means of recouping some of your share-value losses. Of course, it's sometimes more advantageous to simply liquidate some of the stock. However, if you do this and the stock subsequently skyrockets, then you'll have missed out on those gains. Thus, puts are a way to hedge against share-price drops without divesting. The trick is to buy the right ratio of puts to actual shares, based on your assessment of the stock's downside and the cost of the puts.
  • Use puts as a hedge against indexes you own. Puts can be used in the same basic way to protect, or maintain a hedge, against losses in a given index of stocks. However, it is paramount that these puts closely match the indexes that they're purchased to protect. And, as an individual investor, it's best to stick with puts on indexes that you already own, in the right proportion to the amount of the index you own.

Next: The skinny on futures

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