New traders and investors are often overwhelmed by the different financial
products available. hey are kept busy enough trying to understand and choose
between stocks, preferred shares, bonds, mutual funds, closed-end funds, ETFs
(Exchange Traded Funds), UITs (Unit Investment Trusts), REITs (Real Estate
Investment Trusts), and CMOs (Collateralized Mortgage Obligations).
And now you want to add options?
You must understand that whenever a new product is created, there are always
new variations designed to fill slightly different needs. 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.” he Model T was
only meant to solve the broader issues of transportation, namely, getting from
Point A to Point B.
But once the Model T appeared, others soon came to market with modifications
to solve different problems. Today we have many variations such as SUVs, vans, fourwheel drive trucks, extended cabs, crew cabs, compacts, hybrids, and convertibles.
While they are all forms of transportation, they fill different needs.
he financial markets are no different from any other product. As problems
arise, new financial products are developed to handle them. he 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. hat 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 with which the company could grow.
he creation of the stock market solved a very important problem of raising
capital but it also introduced a new problem. hat problem is 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 corporations in
the world. Later that year, 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 are stocks 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 stock
investing. And that’s exactly the problem that options solved.
Risk for Sale
Believe it or not, the options market was designed to allow
investors to either accept or transfer risk. he options market is
technically a market for dealing in risk. You’re probably wondering
who would ever want to willingly accept risk. Odd as that may
sound, we do it all the time. When you buy an auto insurancepolicy, you are paying a fee to the insurance company. In exchange for that fee, it is
accepting the risks associated with you having an accident. he insurance company
is accepting risk in exchange for cash. You are paying cash in exchange for transferring
the unwanted risk. he agreement between you and the insurance company creates
an intangible market – 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.
his 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 car insurance market to be risky since we use it to transfer risk
away from us. However, the insurance companies see it quite differently. It depends
on which side of the agreement you’re on.
he options market works a simple principle: While many investors wish to
reduce risk, there are some people who actively look for risk. he latter are called
speculators. 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
out there who are willing to accept risk in the stock market, wouldn’t it make
sense to be able to transfer it to them? Of course, in order to make it worth their
while, we will have to pay them some money 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. So 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 willing to accept that risk. Investors who do not understand this interplay between investors and speculators hear both sides of the story and that’s
where the confusion comes in.
Unfortunately, this confusion often makes many investors avoid options
altogether. his is a big mistake in today’s marketplace. As our economies expand,
our financial needs increase; hat’s why you see so many new financial products
coming to market. Each product is different – sometimes only in small ways – but
each provides the 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. If you’d like to increase the risk and speculate more efficiently for
bigger profits, options are your answer too.
Let’s get started and find out how you can improve your investments from this
mysterious market.
