Knockout Roses. A Little Early Spring Color Managing Your Money. In these difficult times everyone is afraid to take risk. Unfortunately, there is no risk free investment. Choosing only so-called risk free investments can result in certain loss. For example, if you try to buy only short-term CDs, your return is less than 1%. This is less than the rate of inflation which means you can't buy as much with the money you've invested as you could when you made the investment.
The Stock Market Has Manageable Risk. One way to manage your risk in the stock market is through the use of options but you have to understand certain basic principles before you venture out. Most people won't bother to learn these principles because they think they are too complex and too risky. The fact is they are simple to understand and utilize in a safe manner.
An Option Gives You The Right To Buy Or Sell At A Specific Price. For example, suppose your neighbor owns the lot next door to you and is asking $100,000. You don't have the cash right now but are expecting a substantial inheritance within the next year. You don't want someone else to build next door so you approach your neighbor and offer him $5,000 to hold the property until next year at which time you will pay him the full asking price. He accepts your offer because he will net $5,000 more when you make the purchase, or if you don't buy, he gets to keep your $5,000. This is a simple transaction to understand.
There Are Two Components To An Option's Value. 1. Intrinsic value. If the lot in question is worth $102,000 and you have an option to buy at $100,000 you are getting $2,000 more of value than you are paying; therefore, the intrinsic value is $2,000. 2. Extrinsic value or premium. Since you are paying $5,000 for an option that has a value of only $2,000 you are paying $3,000 in premium. This leads us to one of the only sure bets in the market place.
On The Day The Option Matures, The Extrinsic Value is Zero. The buyer of the option naturally hopes the property value will increase more than the amount of premium (extrinsic value). If it hasn't he has overpaid by $3,000. Think about it. It is really a simple concept. Both parties are managing their risk. If the price drops during the holding period, the option seller has an extra $5,000 to help him bear the loss. If the price increases, the option buyer has his price set at $100,000. Of course, he has paid $5,000 for that privilege.
How Do We Use This In The Stock Market. One way is to harvest your gain and keep the potential for growth. As an example suppose you own 1000 shares of 3M for which you paid $50,000 for three years ago. You have an another attractive investment opportunity and you need your cash. You also are concerned that the capital gain tax is going to increase to 28% during the next year. To top it all off, you believe there is considerable growth potential left in the shares. Here is one way to handle that dilemma. 1. Sell your shares at the current market price of $86,000 and purchase an option to buy the shares between now and January 2014 at $80,000 for $13,000. This way you get the lower capital gains rate, you can make your attractive investment and you can participate in any future growth. Will this work for everyone? No. It will depend on your perception of the attractiveness of the alternative investment, how likely it is for the increase in the capital gains tax and how strongly the option buyer believes in the potential for growth of 3M stock. It may be a good or bad deal but its definitely one that the investor should be aware of.
This is but one example of how you can use options to accomplish your investment goals. I have published this material before and I doubt that many took advantage of the opportunities created by options. If you invest in the markets, you owe it to yourself to explore these opportunities.
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