A Very Gentle Introduction to Options

Investing In The Stock Market

Investing in the stock market is always a favorite topic. Some say don't invest in the stock market because it is complicated. Others, it is just too risky -- they invested in the stock market but lost money. A few claim it is just outright gambling!

And yet, more Americans than ever own stocks, around 58% in 2022. The stock market, estimated to be $109 trillion, remains the best place to invest and offers the highest return. It is true that the stock market has risks and can be confusing, especially if you are not cognoscenti and undisciplined. How much do you know about the stock market? Are you disciplined? Or do you feel FOMO and missing out on all the gains you could make?

Buying Shares of Stock

Let us say that you are an Apple Mac fan. You invested $19,948 and bought 100 shares of AAPL stock for $199.48 per share but panicked when you lost $1,931 of your investment because the stock lost $19.31 (9.68%) to $180.17. You have buyer's remorse and keep thinking the stock could keep going down and your losses higher. 

The Price Could Go Down

What could you do to limit your losses? Suppose the maximum loss you could afford is $448 (2.24%) out of the $19,948 investment. You could place a stop-loss order at $195 with your broker; when the price falls below this target, your broker will sell your shares of stock at Market Price. A stop-loss order is not the best approach because it is susceptible to a head-fake by the market. The stock price could slide below the target to trigger the sale and subsequently rally above the target. In this case, not only did you unnecessarily lose your shares of stock, but your losses could also be more than you can afford because, at market price, the selling price of your shares could be lower than your target.

You Need Insurance

What you need is insurance. What kind of insurance will limit your loss? Suppose you can get insurance to guarantee that the most you could lose is $448, and in exchange, you are willing to pay an insurance premium of $575. By spending $575, you limit your losses to only $448 and still be in play to realize gains if the stock price rises. The worst possible case is that you are out $1,023 ($448 + $575). Is this a good deal? Absolutely! 

Options Can Help

An Option gives its owner the right to buy or sell stock (or index) at a specified price during a given period in the future. There are two kinds of Options: a PUT Option and a CALL Option. A Put Option gives its owner the right, but not the obligation, to sell a security. If you buy the Put Option "AAPL Feb 16 '24 195 PUT" for $5.75 (the premium), it will guarantee that when AAPL is trading for less than $195 (the strike price), you will be able to sell the 100 shares of AAPL you already own at the strike price of $195 until February 16, 2024 (the expiration date). Since an Option contract controls 100 shares, you pay $575 (100 shares X $5.75) as the premium. It is precisely the insurance that you are looking for!

The combination of buying the shares of stock simultaneously with a Put Option is called a "Married Put." A "Protective Put" is identical to a Married Put, but in a Protective Put, you buy the Put Option after the shares of stock.