For most U.S. adults, finances remain somewhat of a mystery. Don’t get me wrong; we can balance our checkbooks (or at least check our balance online) and pay our bills. But when it comes to understanding how money and investments work, generally lack even the basics. In a May 2014 article published on TheAtlantic.com, it was reported that only 30 percent of Americans surveyed responded properly to 3 questions relate to interest rates, inflation and stock purchases.
Many may simply consider having a 401k or a Roth IRA enough of an investment strategy. They choose a certain level of risk (sometimes with the help of an individual advisor, other times with a group advisor), the amount of money they want to invest each month or year and then read the statements when they arrive.
Although this may be a relatively good strategy for new or young investors, it can be limiting in the long haul. Exploring alternative strategies with a trusted investment advisor, however, is the next step towards making your money work better for you.
One of those is an options investment strategy. An option gives an investor (called a holder) the right to purchase a stock from another investor (the seller, or writer) at a specific price within a specific time.
The following is an extremely simplified version of the opportunities which can result:
You own 100 shares of XYZ Corp., valued today at $100 each. I believe the price of those shares will be worth $110 each eventually, and so I pay you $1 per share as a “hold” which allows me to purchase your stock at $105 within 30 days.
Immediately, as the writer, you have earned $100 ($1 hold per share x 100 shares). Furthermore, if the stock price does climb to $105 and I exercise my option to purchase it, you will earn an additional $500.
If the stock doesn’t climb to $105 per share, I wouldn’t exercise my right to purchase it. You’re still $100 ahead, continue to own the stock and perhaps have the opportunity for another hold to be placed on it. In turn, I lose the $100 I’d paid you for those options.
So why would anyone want to become an options holder? Because options can be extraordinarily profitable. Suppose, within the scenario above, the stock price soared to $120—far beyond my expectations. I exercise my right to buy at $105. If I wanted to do so, I could sell those shares immediately and gain an immediate profit on each one in the amount of $14 ($120 value – $105 share price – $1 hold fee). I could also hold the stock in the hopes it would further improve in value.
Again, this is an extremely simplified example, but as you can see both writers and holders have the chance to earn money utilizing options strategies as part of their investment portfolio.
Here are a few things to keep in mind, however:
- Options are available only on blue chip stocks, and require the purchase of lots of 100 stocks or more. As such, investing in options usually requires a minimum of investment of $25,000 or more.
- It is critical to work with an investment advisor you know and trust, who understands your individual situation and your goals.
- Whether as a writer/seller or a holder/buyer, investing in options should be considered a long-term strategy, not a short-term one.
- As with any type of investments, stock options involve a certain amount of risk and therefore are not right for every investor.
So before you continue doing the same types of investing you’ve always done, explore what options strategies can do for your portfolio in the long run. And in the meantime, be sure to read up on interest rates, inflation and stock risk in case you get surveyed soon, too.
Questions? Comments? We’d love to hear them.
Note: The opinions expressed do not constitute investment advice. Independent advice should be sought where appropriate. This article includes general information only and does not take into account the individual objectives, financial situation or needs of any person.