Exploring Options

Financial investing often conjures up images of ocean-front mansions, yachts, private jets, and more recently, CEOs serving extended jail sentences.

But finance isn’t limited to the rich and famous – jailbirds or not. It is for everyone sending kids to college, preparing for retirement, outpacing inflation, or just supplementing income. No matter what your reasons, inherent risks create fear, which lead to bad decisions and poor results.

This course will greatly change the way you see investing. Risks you now fear will vanish. Opportunities will appear that you never dreamed of. After completing it, you’ll discover ways you never thought possible to control the risks and rewards associated with buying shares of stock.

If you’ve ever lost a significant amount of money from holding shares of stock, you can prevent that from happening again. If you’ve ever turned down a stock purchase because it was too expensive, you’ll now be able to afford it. If you wish to make money in the stock market whether a stock rises or falls, we’ll show you that as well. Would you like to protect capital gains without selling your shares? That’s easy to do. Creating monthly income, increasing cash efficiency, diversifying, and hedging can also be added to the list. Most of all, you’ll never have sleepless nights again worrying about how the erratic behavior of the stock market will affect your portfolio.

But wait a minute. Isn’t this course about options? Aren’t they incredibly risky? How can risky options decrease risks in the stock market?

If you’re new to options, you’ve probably heard that options are risky and more suitable for comparison to legalized gambling or the dog tracks. That risky reputation is really a misperception mostly due to the financial media that, of course, only reports when things go wrong. The truth is that options by themselves are not risky but they can be used in risky ways.

To classify an option as risky is like saying a wrench is dangerous. To Bruno the mechanic, it is an invaluable tool. But in the game of Clue®, a wrench in the hands of Professor Plum or Miss Scarlet can be a formidable weapon. The same tool that brings your car to life can also leave you dead in the library. It all depends on how it is used.

Options are just one of many assets available to you in the financial markets. But you can think of them as tools that allow you to custom tailor risks and rewards. Depending on the risks you choose to accept or avoid, options can be used in a myriad of ways ranging from ultra conservative to recklessly aggressive.  

For example, at one extreme, we can use options to create portfolios that have zero risk. That’s right, none. That is, we can build a stock portfolio that is guaranteed to increase to a certain value at a future date and therefore behave like a Treasury bill.

At the other end of the spectrum, we can create portfolios with so much leverage that a small percentage change in a stock’s price could bankrupt a large financial institution. This is, in fact, what happened in 1995 when Nick Leeson destroyed the historic Baring's Bank by recklessly gambling in the futures market in an attempt to support some options positions that had already gone bad.

If the leverage is great enough, even well capitalized banks cannot withstand the pressures. (For a firsthand account of how Mr. Leeson created one of the greatest financial disasters in history, check out the movie Rogue Trader.  It’s a great lesson in what can happen if options are used in the wrong way.)

As you might have guessed, any shade of risk between these two extremes is possible too. It all depends on what you’re trying to accomplish and the risks you are willing to take to reach your goals. Naturally, only the devastating stories are reported by the financial press and that’s why options have earned such a risky reputation. After taking this course, you’ll see there’s another side to the story.

So how can you explore the world of options and find out how your style of investing or trading can benefit from their use? That’s exactly what this course is designed to do. It was developed to provide you with all the necessary information so that you can understand why options are more popular than ever and becoming an important tool in hedging the day-to-day risks of the stock market.  

Are you ready to start your journey into the most powerful and flexible tool available to investors? Okay, let’s start by answering a frequently asked question. That is, why is there an options market in the first place?

Why is there an Options Market?
New traders and investors are often overwhelmed by the different financial products from which to choose. They are kept busy enough trying to understand and sort through the various stocks, preferred stocks, bonds, mutual funds, and ETFs (Exchange Traded Funds). And now you want to add options to the list?

You must understand that whenever a new product is created, it creates new opportunities which in turn create the need for other products. For example, when the Model T was first invented, it solved the broad problem of transportation. People didn’t really care what it looked like. In fact, it is rumored that Henry Ford once quipped, “Customers can have any color they want as long as it’s black.” The Model T was not meant to solve the less important issues surrounding transportation. It was just designed to get you from Point A to Point B.

But once the Model T appeared, new opportunities arose. People now wanted cars for reasons other than general transportation. The market responded by creating vehicles with modifications to solve different problems. Today we have many variations such as SUVs, vans, four-wheel drive trucks, extended cabs, crew cabs, compacts, hybrids, and convertibles. While they are all forms of transportation, they fill different needs.

The financial markets are no different from any other product. As new products are created, new problems arise and new financial products are developed to handle them. The stock market was created as a way for publicly traded companies to raise cash. For example, in March 1986, Microsoft had its IPO (Initial Public Offering) and sold 2.8 million shares for $21 per share. That amounted to an instant check for $58,800,000 for Microsoft. In a relatively short time and very efficiently, Microsoft created nearly 59 million dollars for them to grow and all because they could quickly sell pieces of the company to the public.

The creation of the stock market solved a very important problem of raising capital but it also introduced a new problem – risk. If you buy shares of stock, you are buying a piece of the company and that purchase creates the potential for high rewards. Many investors who bought shares of Microsoft in 1986 are millionaires many times over today.

But that potential for high reward comes with the potential for high loss. In early 2001, Enron was regarded as a market leader in the energy trading business and one of the largest, most respected, corporations in the world. Many brokers and money managers considered it to be a staple for even the most conservative portfolios.

But later that year, it stunned Wall Street as it filed for what was to become the largest bankruptcy in United States history. Many investors lost their life savings by investing in Enron. So is investing in the stock market good or bad? Obviously, it depends on what happens to the stock’s price and that is something we cannot know beforehand. In other words, there is risk associated with stock investing. In order to make the financial markets run smoother, it would be nice to invent ways to manage the risk involved with the stock market. And that’s exactly the problem that options solved. But if options are not inherently risky, why do they have such a risky reputation?

Risk for Sale
Believe it or not, the options market was designed to allow investors to either accept or transfer risk. The options market is technically a market for dealing in risk. You’re probably wondering who would ever willingly accept risk. Odd as that may sound, it is done all the time.

When you buy an auto insurance policy, you are paying a fee to the insurance company. In exchange for that fee, they are accepting the risks associated with you having an accident. The insurance company is accepting risk in exchange for cash. You are paying cash in exchange for transferring the unwanted risk.

The agreement between you and the insurance company created a market for an intangible commodity – the market for risk. So to answer the question of who would ever willingly accept risk, you must remember that someone is getting paid to accept that risk. If the fee is high enough, you can be sure that someone will step in and accept the risk.

This highlights why the options market is perceived to be so risky. After all, it is a market whose only product for sale is risk. As stated before, the riskiness of options depends on how you’re using them but now we can state it a little more clearly: It depends on whether you are transferring or accepting risk.

None of us would consider the contract we have with our car insurance companies to be risky since it is used to transfer risk. The worst that can happen is that the policy expires without one claim against it and we lose the premium. However, the insurance companies see the agreement quite differently. For the relatively small premium they receive, they could lose millions of dollars. It depends on which side of the agreement you’re on.

The options market works on a simple principle in that, while many investors wish to reduce risk, there are some people called speculators who actively look for risk. Speculators are willing to gamble for big profits; they aren’t afraid to take a long shot if there is potential for big money. People who patronize casinos and play state lotteries are acting as speculators.

If there are speculators in the world who are willing to accept risk, wouldn’t it make sense to be able to transfer it to them? In other words, it would be nice if we had a way to efficiently transfer some of the unwanted risk associated with stocks over to those who do want the risk. Of course, in order to make it worth their while, we will have to pay them a fee to accept that risk.

So if there is a risk you wish to avoid, you can do so by purchasing an option. Conversely, if there is a risk you're willing to assume, you can get paid through the options market to accept the risk for someone else.

While one investor may be using options to avoid risk, it is possible that the person on the other side of the trade is a speculator actively seeking risk. Investors who do not understand the interplay between investors and speculators will never understand why options are not necessarily risky.

Unfortunately, this confusion often makes many investors avoid options altogether. This is a big mistake in today's marketplace. As our economies expand, our financial needs increase and that's why you see so many new financial products coming to market. Each product is different, sometimes only in small ways, but each provides a solution to a specific problem.

Options allow you to selectively pick and choose the risks you want to take or avoid. And that is something that cannot be done with any other financial asset. Because you can select the individual risks to take, options can be used in very conservative as well as very speculative ways. It’s all up to you. If you’d like to make the stock market a less risky place, options are your answer. (On the other hand, if you’d like to increase the risk and speculate more efficiently for bigger profits, options are your answer too.)

So if you’re convinced that options are not necessarily risky, let’s continue and find out how your style of investing can be enhanced by this mysterious market. 

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