Just like a stock or a bond, an option is a security. Options are derivatives, deriving their value from another underlying asset. If you are unaware of what a derivative is, you should take a look at my earlier post on financial derivatives.

If you own an option, you basically have the option to buy or sell a block of shares of a specific stock at a specific price, within a specific time frame. Notice how the word specific occurs in the previous sentence 3 times. This shows why options are risky—because you have to be right about 3 things. You must choose the right stock, predict the degree of its move, and the time it will take to get there. You must make 3 right choices, otherwise, if you are wrong on just one, you’ll lose your money.

Still confused? Well, basically when you buy an option, there is a contract with set terms, giving you an option to buy or sell a specific stock, index, or future at a specific price on or before a specific date, but it is not an obligation. You don’t actually own the stock, nor do you ever have to buy the stock to profit or lose money on options.

Options allow traders to make money fast if they’re right, but when the market reverses, they can walk away and owe nothing! There is an expression, “your loss is limited to what you paid for an option” but note that can also mean you can lose 100%!

There are 2 main reasons why investors use options: to speculate and to hedge.

Options can be extremely volatile and risky investments. Option trading is not suitable for everyone because of its high risk. You definitely need to have a clear idea of what you are doing and understand all the terminology that is associated with the options market. This is what Warren Buffett has been warning investors about for years: the unregulated and growing use of derivatives.

However, options aren’t inherently bad. They also provide a hedge to protect investors from losses in particular stocks.

There are 2 types of options: puts and calls.

1) Call Option- gives you the right to buy an asset at a specific price within a set period of time. You buy call options if you expect the price of the underlying stock to rise before the option expires. If the stock price rises, you would make a profit because you previously bought the stock for less and now you can resell it for more. Call options are similar to having a long position on a stock.

2) Put Option- gives you the right to sell an asset at a specific price within a set period of time. You buy put options if you expect the price of the underlying stock to decline before the option expires. If the stock price declines, you would make a profit because you can now sell at a higher price. Put options are similar to having a short position on a stock.

There are 4 types of participants in the options market:

1) Buyers of puts
2) Sellers of puts
3) Buyers of calls
4) Sellers of calls

Buyers of options are called holders and sellers of options are called writers.

It’s okay if you don’t understand options because it is considered very confusing and is often avoided by beginners to the stock market. But depending on the type of trader that you are, you might enjoy options trading so you can look more into that later.

Coupons. A penny saved is a penny earned. Do not feel embarrassed about using a coupon that is only fifty cents discounted off the original price. This saving can contribute to paying off some of your ridiculous transaction commissions that our online trading broker website robs from us (E-Trade, Scott-Trade, etc.). Eight dollars for a transaction just to buy some stocks and another eight just to sell them? That’s absurd, especially if you haven’t made any profit from the stock. These commissions do contribute to losses and minimizes our profits! So every penny saved helps.

But watch out for those coupons. They can be evil sometimes. In a sense, coupons lure you in to buy the items that you might not need at all. This again relates to trading: don’t buy a stock simply because it looks good, without appropriately studying the stock or having a reasonable trading method. Just like how you shouldn’t use the coupon because the item is at a cheaper price, you should not buy a stock simply because it is cheap. For example: penny stocks. Most of us can afford to buy a couple of penny stocks but why do we not? There is a very high risk to them and therefore, we cannot associate buying something only because they’re cheap. Cheap prices are attractive but sometimes we need to control our desires if we still want to have some decent amount of money in our bank.

Also, just because an item has dropped in price (perhaps due to the coupon or a sale), which makes it cheaper than it initially was, does not mean that you should buy it. Many of us do so because we believe that the price of the item will go back up so we tend to take advantage of sales and coupons, even for those items that we do not need. However, we have to be careful to not use the same method when it comes to trading! It is so easy to get attracted to cheap, fallen prices but remember: We cannot buy a stock just because it has dropped in price, thinking foolishly that the stock “has” to go back up with no apparent reason other than that it “has” to! That would be speculation. What comes up most often comes down at times, but what comes down…unfortunately does not always come back up all the time (as you can probably tell from all our bankrupt companies). Therefore, we cannot assume that the stock price will go up. The stock market has no guarantees: the stock can keep going down and disappear…and so can your investments.

I agree that the idea of buying a large block of $1, $2, or $5 stock and watching it double is exciting. The only problem is that your odds of winning the lottery may be better. Here’s the fact: investing in stocks is not the same thing as buying a car or a shirt on sale. Cheap stocks involve far greater risk. A historical fact is that of best-performing stocks in the last 45 years, the average per share price before it doubled or tripled was $28 a share.

Given this comparison between coupons, sales, and trading, I hope you do not let prices and its mere appearance (without studying, perhaps, fundamental analysis or technical analysis) affect your decision whether or not to buy a stock. Think before you act.