by Brian Palmer

Created on: February 06, 2009   Last Updated: November 02, 2009

The stock market is full of exotic and confusing language that can be quite intimidating to individual investors. But as most investors know, once you get past such jargon as "net present value", "debt ratio", "acid test" and "operating margin", there are great opportunities to be had in the stock market.

And the same can be said for the options market: Once you get past the seemingly never-ending jargon of "covered calls", "long puts", "straddles", "strangles" and "bear hugs", you will similarly see the vast opportunities that await you in the options market.

But- I would be remiss if I did not give you fair warning:

Options are risky.

Very risky.

In fact, if you are just starting out in options, plan on losing some amount of money at first...

Now if still you feel up to the challenge, read on...

OPTIONS BASICS

An options contract is a contract you can buy which gives you the RIGHT to buy shares of stock at an agreed upon price, at some point in the future. For example, if the stock XYZ is currently trading around $95, but you think it will rise to $110 a few months from now, you could buy an option that would lock in the buying price of $100.

If the stock does rise to $110 (or higher), you can execute your option, and buy shares at $100 - you've locked in a 10 dollar profit per share!

If the stock does not rise beyond $100, you can let your contract expire, and all that you have lost is the initial investment in the contract itself.

This type of option is called a "Long Call": it allows a purchaser to make money when the stock rises past a certain price. The price the option is written for is called the "Strike Price" (in our case, the strike price is $100).

Since options require a modest upfront expenditure, you have a limited downside risk: You only pay for the price of the option, which is usually a small amount of money, and this is the most you can lose.

Meanwhile, the stock XYZ need not stop at the $110 level: It could go to $120, $130 or beyond, meaning your potential gains are unlimited!

A similar device can be used when you think a stock will fall in the near future. A Long Put allows you to sell a stock at a predetermined price, at some point in the future.

For example, if ZYX is trading at $110, but you think it should be at the $100 level, you could buy a long put with a strike price of $100, which would make money if the ZYX fell far enough below the $100 level.

TO PLACE A TRADE

The first step in buying options is to get approval from your broker.

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