Beachside Resident #11 Options pt. 1

“I was born with nothing and I still have most of it left.” Option players are similar to compulsive gamblers. With varying degrees of experience, most will walk away with less than they started with. There are ways to use options in a positive manner but we’ll save that for now and start with the destructive side because it’s more fun.

Let’s start with some basic terms. As usual, I’ll save the more in-depth stuff for the web site. Options are contracts that rise and fall in value based on the value of an underlying asset. There are two types of options, calls and puts. Every option has an expiration date.

Calls are a contract to buy, meaning if you have one call option to buy XYZ stock, you have the right to buy XYZ at a specific price until some future date. So imagine you spent a couple hundred dollars and bought this contract that guarantees you can buy 100 shares of XYZ for $25. Later that day, XYZ announces a new product will make them tons of money. The great news drives their stock price from $25 per share to $50. The stock doubled in price but the call option you bought for $200 is now worth $2500. Giddy up.

Put options are a contract to sell and perform the opposite of calls. The value of a put will go up if the underlying stock goes down. It’s like skating on the other side of the ice.

The appeal of options is obvious. Investment loss is limited to the original cost, in this case $200. Potential gain is enormous as illustrated. But alas, there’s a hook.

Options are priced to fail. If this is doesn’t scare you away, read it again until it does. The most likely outcome is the stock will wiggle around and go nowhere and the option expires worthless. Maybe you’re out $200. Maybe you bought 10 contracts and you’re out $2000. Either way, it’s a 100% loss.

Don’t buy options. Calls or Puts.

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Beachside Resident #10 Fees and Other Random Rants

To make a good impression, an advisor takes his potential customer down to the local marina. He points to a yacht and says “This one’s mine”. He gestures further down at a bigger boat and then a monster on the end and proudly announces “There’s my managers boat and our directors power yacht”. Clearly impressed, the potential customer asks “Where are your clients boats?”.

Some jokes are funny because they’re true. This one is sad because it’s based on truth. Advisors who work through banks, insurance companies and big brokerage firms do not build wealth. They feed off it. If they’re telling you what to buy and you really don’t understand, that should be a huge warning flag. There’s nothing wrong with asking questions to understand your financial security.

One last thing on sales, avoid annuities, loaded mutual funds, reverse mortgages and precious metals from TV ads. If you already have one or more of these don’t rush to sell. It might cost you even more to get out. Get independent help. I’ll leave more information and specifics on my website. ’nuff said.

This months column marks a turning point in our discussion. We have covered the markets and various investment types then built a typical portfolio using the asset allocation model. In short…the way it should be done.

In future issues, we’ll dive into the way it shouldn’t be done. I’m specifically referring to day trading, charting and options. Better you learn about it here than from someone trying to sell you something.

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