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Opens the scrolled simulated dialogImportant Disclosures

Why Invest in Options

Options contracts are flexible investments. You can use them to try to enhance your portfolio in rising, falling, and neutral markets. You can also use options to help manage certain types of portfolio risk. You have to understand how call and put options work, as well as the difference between buying and selling contracts, to know which choices to make. You also have to anticipate market movements correctly. And one more thing. You have to read this: Characteristics and Risks of Standardized Options.

Options for different kinds of investors

If you're bearish and expect a stock market downturn, you can buy put options on one or more stocks to try to profit from falling prices whether or not you own the underlying stocks. You can also buy put options to protect long-term unrealized gains in a stock you own. The contract gives you the right to sell it at a price that's acceptable to you on or before the exercise date. For the cost of the premium (plus commissions), you can try to lock in a minimum profit for the duration of the contract.

In contrast, if you're bullish and expect a market upturn, you can purchase call options on one or more stocks to potentially benefit from gains in those stocks' prices. The premiums will be a fraction of the amount you'd need to actually buy the stocks. If the stocks' prices do go up, you can exercise if you choose and buy the stock at below its current market price. Or you may be able to sell the option contract itself for more than you paid to buy it.

If you're a conservative investor, you might use options to provide some protection against possible drops in value. What's more, selling options may be a way to increase your income. For example, say you would like to own 100 shares of a company now trading at $46, and are willing to pay $40 a share. You sell a put with a strike price of 40. If prices rise, your option will expire unexercised and you keep the premium. If prices fall and the option is exercised, you'll buy the shares at the acceptable $40 a share price.

If you're an aggressive investor, you might use options to speculate. By using leverage, you don't have to commit a large amount of money. But it's possible to achieve a greater percentage return using options than you could by owing the underlying stock. On the other hand, this strategy is potentially very risky since it's possible you could lose at least the entire amount you invested and perhaps more.

When it works

Options let you potentially benefit from movements in a stock's price at a fraction of the cost of owning that stock. Here's an example of an options strategy that worked for one investor: Bob and Mary agree that stock in company A, which is currently trading at $50 a share, will rise in the next few months. Bob spends $5,000 to buy 100 shares. But Mary buys a call option with a strike price of $55 instead of buying stock. The premium for the option is $2 a share, or $200 a contract, since each contract covers 100 shares. If the price of company A's shares rises to $60 and the premium goes up to $5, she can sell her options for $500. That's a $300 profit or a 150% return on her investment. Bob, who bought 100 shares at $50 a share, could make a $1,000 profit by selling his stock, or a 20% return on his investment.

There's no guarantee that this would be the result in any situation, however. If the stock price rose after the option had already expired, Mary's option would have sold for less than $2 a share or expired worthless.

Reducing your risk

Buying options helps to manage risk by limiting potential losses to the cost of the premium if the security's price moves in the wrong direction. Additionally, you have the right to sell your contract (provided there's a willing buyer out there) if that allows you to recoup some of your initial cost.

You can also hedge against losses by buying options to protect long-term profits against falling prices. For example, if you're concerned that the price of your shares in a certain company is about to drop, you can buy put options that give you the right to sell your stock at the strike price, no matter how much the market price drops before expiration. For example, if you own stock that you bought for $30 a share with a current market price of $50, you could buy a put contract with an exercise price of $45. If the price fell below that level, you could exercise and keep most of your profit.

Remember, though, that while hedging may help you manage risk, all investments, including options, carry some risk, and returns are never guaranteed. Further, if you sell options to enter a position rather than buy them, you may be increasing rather than reducing your risk.

Modest profit potential

Most options strategies have limited risk but also limited profit potential. So they're not get-rich-quick investments, including for investors who use options to speculate and so face greater risks. Transactions generally require less capital than equivalent stock transactions. But profitable outcomes return smaller dollar figures, although a potentially greater percentage of the investment, than equivalent stock transactions.