Options are a financial tool that are commonly misunderstood. Options are deemed by many as risky, and therefore should be avoided by the average investor. Although there is some truth in this statement, the risk lies primarily in a lack of knowledge of how options work, rather than the inherent risk in options themselves. Driving a car is risky, if you do not know how to drive one. However, with knowledge and practice, the risk of driving a car is mitigated significantly. The risk will never go away completely, but it can be minimized. The same is true with options. If an investor who knows very little about options who attempts to trade in the options market, it would be a very risky proposal. However, with a little instruction and some practice, option trading can actually decrease the risk you expose your IRA and stock portfolio to every day.
Options have been a publicly traded financial instrument in the stock market since the early 70's. Just like a share of a company like McDonalds, I can buy and sell and option. The original purpose for the creation of options was to control risk, and if used in a method consistent with their intent, you as an individual investor can actually control risk in your investing portfolio rather than increase risk. The options can be traded individually, or they can be combined with a stock that you own, or want to buy to help either offset risk, or enhance returns.
There are two types of options. A Call option is the right to buy stock at a specific price on/or before a specific date. A Put option is the exact opposite. It is the right to sell a stock at a specific price on/or before a specific date.
There are 4 primary reasons investors use options.
2. Protection (Insurance)
3. Cash Flow
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