Stocks: Ownership in a Company
Stocks represent ownership in a company, issued in the form of shares. Shares signify a portion of ownership in the company. Some shares come with dividends or additional complexities, but at their core, they represent equity in a business.
When discussing options, these shares are often referred to as the underlying asset, as options are derivatives that depend on the value of these stocks.
Options: A Derivative Tool
Options are not about owning the underlying stock but rather represent the right to buy or sell shares of it.
Each options contract typically controls 100 shares of the underlying stock, regardless of the stock’s price. You can control 100 shares for a fraction of the cost, with the potential for exponential profits, though options carry a greater chance of losing your entire investment.
Options can apply to many asset types, including currencies and indexes, but for simplicity, we’ll focus on equity options.
Bonds: Fixed-Income Investments
Bonds represent a fixed obligation by a company, government, or other entity to repay a certain amount of money, typically with interest, over a specified period.
Bonds are essentially loans made by investors to entities. In return, investors receive regular interest payments (known as coupons) and the original principal at the bond’s maturity date.
Key Bond Metrics:
Coupon Rate: The total interest paid over time, divided by the bond’s face value.
Face Value: The bond’s worth at maturity.
Though bonds are not central to this guide, they are a crucial investment option worth exploring.
Key Concepts for Stocks
Going Long: Betting on Growth
To “go long” means buying stock with the expectation that its price will rise, reflecting a bullish outlook.
Example:
You purchase 5 shares of Apple (AAPL) at $150 each, spending $750. If the price rises to $165 per share, you can sell for $825, earning a $75 profit.
Going Short: Betting on Decline
Shorting stock involves selling shares you don’t own, expecting the price to drop.
Example:
You short 5 shares of AAPL at $165, receiving $825. If the price drops to $155, you buy back the shares for $775, making a $50 profit. However, if the price rises, you could face a loss.
Key Takeaways:
Long (Buying): You profit if the stock price rises.
Shorting: You profit if the stock price falls, but the risk is higher and requires careful management.
Why Choose Options Over Stocks or Bonds?
Options offer unique advantages, including:
Leverage: Control large positions with less capital.
Capital Efficiency: Lower initial investment compared to purchasing stock outright.
Risk Management: Use options as insurance against adverse price movements.
Speculation: Take positions on market movements with lower upfront costs.
For example, controlling 100 shares of Apple stock at $150 would cost $15,000, but an options contract might cost only $1,000 with similar profit potential within its time frame.
While stocks and bonds have their merits, options can provide unparalleled flexibility for traders with the right knowledge and strategy.