The Beginning
June 14, 2010
Starting at the Beginning

For readers who came here looking to start at the very beginning, I tried to provide some background before doing that.

It's time to present the options story for the person who knows essentially nothing about using options.

An option is an investment tool.  It can be used aggressively to take big risk, seeking large rewards.  I don't believe in doing that, but many other do.  Unfortunately, when taking such big risk, the chances of success are small.  Most of these traders fall by the wayside.

Options can be used conservatively.  There are low risk methodologies that provide a modest profit potential (there are no huge profits available when you trade conservatively).  This is the trading style I adopt and hope to convince you that playing the with probability of success on your side is prudent.

Options can be used to provide insurance or protection for other investments in your portfolio.  In this use of options, there is no specific attempt to earn additional profits.  With a 'regular' insurance policy, there is a cost to pay.  The good news is that this cost can be very modest when using options.  In fact, it's also reasonable to collect a cash payment when you own such insurance.  Now that's something special.  Of course, there is no free lunch, and that cost free insurance comes with limited profits.  But that's an excellent trade-off for many conservative investors.

When using options, we employ a strategy, which is simply a description of which options to buy and sell. 

There are many possible strategies to sue when trading options, but for now, you will learn much more quickly if you try to understand only one or two such strategies.  This is an education process, and the better you understand the basic principles, and the fewer different trading methods you attempt to learn (at this point), the easier it becomes to grasp the more advanced concepts of option trading.

One example of a strategy is buying a call spread.  For this strategy,  you buy one call option and sell another.  The obvious question is how does one decide which option to buy and which to sell.  Much of the answer depends on what you are trying to accomplish by making the investment.

This specific strategy (buy a call spread) is a bullish play.  Thus, it is to be made only when you are willing to invest cash in a position that profits when the stock moves higher and loses (or probably loses) when the stock holds steady or declines. 

Next time we'll look at constructing a call spread.

Mark D Wolfinger

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