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My Personal difficulty
In my early 20s I saved up some money and I felt that I wanted to prepare for my financial future as best I could. The only difficulty that I faced was that I DIDN’T KNOW WHERE TO PUT MY MONEY?!
I felt that a good start was in the stock market, but again, WHERE?!
The uncertainty of this question kept bouncing in my head until I became obsessed.
After weeks of research, I decided that stocks and options would be the best bet for my style of investing, which is a mix between long term and short term investing. I have been in the stocks and options game ever since.
I wrote this article for young investors who are at the beginning of their investment paths who are hungry for information. This article isn’t going to make you rich and it isn’t a million-dollar investment guide. Rather, this article is going to give you valuable information to become a more wise investor and allow you to depend on your intelligence.
Simply put, a stock is a share (imagine a piece) of a company.
A stockholder has a claim on a company’s assets and future earnings.
That sounds a little big and out of proportion, let’s look at an example:
Dan wants to open and build a Boutique Dessert shop in New York City and needs $1,000,000 to get things up and running. Dan doesn’t wasn’t to take a loan from the bank and instead invests $100,000 of is own money and brings 9 friends, each to invest $100,000. In return, Dan gives each of his friends a certificate stock,
%10 of his company. Each of Dan’s friends who invested is stockholders of his Boutique Dessert shop and each investor holds %10 of
- The company’s assets
- The company building
- The raw materials
- The baking equipment
- Future earnings
After a year of successful pastry making, the shop is now worth $2,000,000. This means that each shareholder has a stock worth $200,000, twice the worth of the stock from the previous year.
The original investors can sell their stock for a %100 profit!
Bottom line if you own a stock, you own a small piece of that company.
That was just an example, but this is exactly how stocks work! Stocks are bought and sold daily in the stock market.
Stocks are very basic. There are two straight forward positions in stocks, a Long position, and a Short position.
In a long position, the stock is owned and then sold. In a short position, the stock is borrowed, sold, bought again and then returned.
I’m sure that didn’t make sense…..Okay, what is a Short?
A short is a position an investor can take when he believes a stock is going to drop in value.
Joe thinks a particular stock is going to drop in value. Joe borrows that stock from Anne and agrees he’s going to give it back to Anne in a month. The market value for the stock is $100 and is now in Joe’s possession.
Joe sells the stock for $100. A month later that same stock is now worth $50. A moment before Joe gives the stock back to Anne he buys it for $50.
Joe makes $50 on zero money down and Anne gets her stock back as promised.
This can get messier if the stock goes up.
If you are in a long position and a buyer, you want to find a worthy stock at a low/fair price. Possibly hold it for the long term in hopes that the stock gains more value and sell or maybe sell the stock at a high price if it jumps.
Every investor is different depending on his or her strategy.
That’s the basic understanding of stocks!
An option is basically a contract that allows the recipient (the Buyer) the RIGHT (not the obligation) to buy or sell a specific asset at an agreed price and at a known time frame.
An option can involve any asset, a car, a building, a piece of land, etc.
Were going to focus on the stocks in this article.
There are two sides to every trade. The buyer of the option or seller of the option. The buyer or the seller can decide to trade calls and/or puts.
I know that didn’t seem clear, roll with me.
The Buyer of the option purchases the privilege to decide what the end result will be of the option. He can buy the option (the right) to buy the stock (Call, aka “Long”) or he can buy the right to sell the stock (Put aka “Long”) at an agreed time.
Of course, to every buyer, there is a seller!
Okay let’s dive a bit further, there are only four basic types of options that we can get into;
- Call option buyer (aka “Long”)
- Call option seller (aka “Short”)
- Put option buyer (aka “Long”)
- Put option seller (aka “Short”)
|BUYER||the RIGHT to BUY stock at an agreed price (aka “Long”)||The RIGHT to SELL stock at an agreed price (aka “Long”)|
|SELLER||The OBLIGATION to SELL stock at an agreed price (aka “Short)||The OBLIGATION to BUY stock at an agreed price (aka “Short)|
Let’s first talk about the Option buyers side of the table:
We have Call Option buyers who have the right to buy a stock at a certain price in the future and we have Put Option buyers who have the right to sell a stock at a certain price in the future.
If you are an Option buyer you are usually paying a premium (an amount of money) to be in that position. Simply put, you are paying for the right to make a choice in the future. You are paying for that choice.
Let’s look at an example, I know that sounded a bit confusing:
A Put Option buyer would pay for the choice to sell a stock at $100 (this is called the strike price, agreed upon with the option seller) and hope the stock will trade for $80 in the market. If that was the case, the Put Option buyer would buy the stock in the open market for $80 and sell it for $100 making $20 in profit [minus the cost of the Put Option of course (the premium)]!
Now that we have an understanding of the buyers’ side, let’s look at the Option sellers side
We have a Call Option seller who has the obligation to sell the stock at a certain price in the future and we have Put Option sellers who have the obligation to buy the stock at a certain price in the future.
Don’t forget, to every Option seller there is an Option buyer to make the deal.
If you are an Option seller you have the obligation [they gave up their right (for the premium)] to sell/buy (depending, if they are in a Call aka “short” or Put aka “short” position) a stock at the agreed amount in the contract at the assigned time.
Just because you are an option seller doesn’t mean you are stuck with the contract. You can sell it to a third party or buy your rights back from the Option buyer.
here’s an example:
A Call Option seller would make a contract with an Option buyer to sell a stock at $100, which would be the strike price(and receive a premium from buyer giving up the Option seller’s right to choose the outcome.)
If the stock goes up to $120, the Call option seller would be obligated to buy the stock at market price of $120 and sell it to the call option buyer for $100 losing $20 in this option deal.
If the stock drops to $80, the Call option seller would have potentially made money (buying the stock at $80 and selling the stock at $100 to the Call Option buyer) BUT because the Call Option buyer paid a premium to decide the outcome of this contract, he wouldn’t follow through with the deal and would allow the contract to expire, only losing his premium.
The key with Option buyers is that they pay money (premium) to the seller and receive the right to decide what they are going to do at the end of the agreed time.
Stocks vs Options
- When buying stocks, you need to have the money upfront to pay for the asset. Options are a contract. If you are the Option buyer, then you need the cash for the premium on hand and if you are the Option seller you don’t need any capital at all!
- Stocks can be passed from generation to generation. Meaning you can sell or buy a stock at any time! Options, on the other hand, have an expiration date.
- If you buy a stock, you believe the stock will go up in value. If that happens, you make a profit when you decide to sell it (if you don’t sell there is no profit because it could just as easily drop back down). However, If you assume the price of a stock is going up in value (a bull market) then as an investor you would Buy a Call Option or Sell a Put Option. If you assume the price of a stock is going down in value (a bear market) than as an investor you would Buy a Put Option or Sell a Call Option.
- Although an investor can leverage stocks by going the Short route, it’s not recommended unless the investor believes a specific stock is going to drop. In the world of Options, the Buyer is the only person who needs cash on hand. The premium for the option is all that is needed when buying an option.
So..Which is better?
Now that we understand the difference between the two,
are options better than stocks or stocks better than options?!
It honestly comes down to what you like better and what works for your risk to reward tolerance. If you’re a beginner investor and you want to get involved in the stock market, stocks are definitely the easiest to understand. If your someone who enjoys living the stock market and learning about investing, options could be great for you.
This isn’t an easy topic, but if you got this down your that much closer to being an intelligent investor.
If there’s something else you want to know just leave a comment!
So what floats your boat? Stocks or Options?
Benjamin is the Co-Founder and CEO of FinancePond. He worked at a private accounting firm before he created FinancePond. Benjamin is an entrepreneur at heart and firmly believes in strong personal finance and investing education. He has a passion for finance and his goal is to cut out the fluff and make personal finance simple for everyone.