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Understanding Options

Options give you the right -- but not the obligation -- to buy or sell a specific investment at a specific price, within a certain period of time. If there is no profit, you can just let them expire worthless. The profit potential is virtually unlimited. But the potential loss is always absolutely limited to the amount you invest and never a penny more.

Most people are familiar with the concept of stock options which come with an employment compensation package. If you join a corporation, they may give you the option to buy stock in the company at a low fixed price, no matter how high the stock price rises.

If your company does well and the stock price goes to a higher level, you exercise the option. You buy the company's stock at the low price, sell it at the higher price and pocket the difference. If the company doesn't do well, you just hold the option and you've lost nothing.

The options available on the market today are essentially the same, with just a few basic differences:

First, most options are shorter term. Stock options, like the type you get as an employee, can be good for many years. But most actively traded options expire in a matter of months. (In the next section, I will tell you about longer term options available called LEAPS, which expire within one to two years. But first let's talk about the most common options, which are very short term.)

Second, today's options are listed on an exchange. They can be bought and sold at almost any time. In fact, investors rarely exercise the option and buy or sell the underlying stock or instrument. Instead, they buy and sell the options themselves. So you can invest in options with the same kind of objective as buying stocks: To buy low and sell high, with no other obligations.

Third, you have access to two kinds of options -- not just options to buy (call options) but also options to sell (put options). When you buy call options, you can profit from a rising market. When you buy put options, you can profit from a declining market.

Fourth, options are available not only on individual stocks, but also on stock indexes, including the Dow Jones Industrial average, the S&P; 500 and the S&P; 100. This gives you the opportunity to, in effect, greatly diversify your options over a wide variety of stocks with a relatively small investment.

Warning: There are also many other options transactions that are more complex, that involve a lot more risk, or both. I recommend you avoid them and stick strictly to buying low and selling high.

Essential Options Terms >>

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