Prosper Newsletter: March 2008 > Stock

You understand that the following information is educational in nature and is not intended to be legal, accounting, or tax advice. You are responsible for your own financial decisions and should consult your own legal, accounting, and tax advisors before making your financial decisions.

Investing in Options

Basics of Option Investing

When you invest in the stock market, you should expect the investment to be long-term. In other words, if you bought penny stocks in January, 2005 for five cents per share, it is highly unlikely that the stock will have risen to one dollar per share by January, 2006. Although you can make a profit very quickly if you purchase stocks wisely (and are lucky), there is a faster and less risky way to turn a larger profit; investing in options.

There are two types of options: call options and put options. The theory behind options is that you set a price at which you either buy or sell a stock during a certain period of time. In the simplest terms, you are betting whether the price of the stock will increase or decrease. With a call, you are betting that the stock price will increase; with a put, you are betting that the stock price will decrease.

A call option is the right, but not the obligation, to buy a stock at a certain price by a certain date. This locks the purchase price of the stock for a set period of time (generally at least ninety days). During those ninety days, the investor can sell the option at its current market price, or purchase its stock at the locked price at any time. If the stock price begins to fall, the investor can also sell the option at its current value to minimize loss. If the investor has not taken any action by the time the options expire, the investor will be out the price paid for the options.

As an example, consider the following scenario. Investor A purchases a call option on Stock Z at one dollar per share. Say the stock price rises and the call options rise to two dollars per share. At this point, Investor A can sell the options to Investor B at two dollars per share and pocket a dollar of profit on each share. Or, the investor could choose to purchase the actual stocks at the original strike price at any time. On the other hand, if the stock or option price decreases, Investor A would have to sell at the current stock price (and take a loss), or be out the amount paid for the call options.

The same methodology applies to put options. A put is the right, but not the obligation, to sell a stock at a certain price by a certain date. In other words, Investor A buys a put on Stock Z at one dollar per share. The price of the stock decreases and the put is now worth $1.50 a share. Investor A could then sell the put options and pocket a profit of fifty cents per share. However, if the stock price increases, then Investor A could either sell at the current price (taking a loss), or be out the amount paid for the put options.

In summary, there are two types of options—calls and puts. Investing in options offers two ways to make money—by either selling option contracts to other investors or by purchasing and/or selling the option's underlying stocks. When selling option contracts, profits are generally smaller but the risks are much less than purchasing stocks. As you invest, consider options carefully; they can be a great wealth-building tool.

Stock Market Volatility

The past month or so has been another volatile time for the stock market. The major indices are down 5% since the beginning of the year. During these volatile times, when the market is up one day and down the next, profitable trading can be very difficult. This is a good time to patiently watch for the right time to enter or exit a trade. Be quick to take profits because you don't know what will happen tomorrow. Keep a close eye on the latest news and act appropriately. Index trades have been very effective during this period of volatility. Many students have profited handsomely from this type of trade in recent months.

Additionally, this is the time of year that stock investors love. Yes, it's tax time. Ok, so maybe you don't really like this time of year. However, each of us has to pay our fair share of taxes. If you profited (or not) from your trading last year, you will receive a W2 from your brokerage stating your income or losses.

If you have experience preparing your own taxes, and if you know how to put together your returns using the information from your brokerage account, it is high time to prepare your taxes. If you are not so savvy with your taxes, you should seek the assistance of a CPA or tax professional. If you perform your due diligence, you should find a good CPA for a reasonable rate. Let your CPA know your situation as an investor and give them any other information that they ask for. A CPA is fully aware of how to use all of your information to make sure that you only pay your fair share of taxes and nothing more. Also, if you invest in an IRA, you won't have to pay taxes on your profits until you actually withdraw the money. Review your taxes and plan to maximize your profits at tax time next year. Happy trading!

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*Please see the Elective Class Catalog in your Success Center for dates, times, and class details.

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