This is the first part of a series called Things Rich People Do, in which we obsess about money. Have suggestions for the series? Leave a comment and let me know.
First off, let me get this out of the way: I worry about money. A lot.
I think it’s pretty common, amongst “creative types,” that in our youths we tend not to care about money. Money is for suckers, we think. Go ahead, trade your life away. I’m going to be true to myself, and pursue my art!
That’s awesome. Really. I mean, I did that. However, at a certain point in your life, it occurs to you that if you don’t make some money, a little bit, at least, you’re going to have to work literally forever. And then maybe you fall in love, and get married (how bourgeois, young you scoffs while rolling his or her eyes), and maybe you want kids or even a house to call your own so that you can retreat from the world and paint, or make music, or whatever it is. Or maybe you just want to travel.
As my dad used to say, “money is freedom.” You don’t have to care about money, and more power to you if you don’t. But if you do, it can be profoundly stressful as a “creative person.” Most of us still aren’t willing to just up and join the corporate world; even if we were, that isn’t exactly so secure anymore, either. So what do we do?
That’s what this series is going to be about: what are some ways we can make money and leave time for our creative pursuits? How do we make a living without ruining our lives?
On with the show.
INVEST ALL OF YOUR MONEY IN GREEK BONDS RIGHT NOW
I wanted to address something quickly before we get into this topic, which is: why would you want to learn about stock options in the first place?
I initially wanted to learn about the stock market as an intellectual exercise. I am not mathematically inclined. I’m not even particularly logical in my thought processes. Learning this kind of skill set seemed like something that was both within reach (unlike, say, astrophysics) and something that would expand me as a person. Also, Wall Street is a hot topic lately, and understanding how it all works seemed like a prerequisite to understanding the news.
I’m also not going to lie: I’d like to be able to make money on the stock market. Despite the doom and gloom on Wall Street lately, you can still make money in the market, especially if you’re focusing on options (which can make a profit when stocks go up or down, as you’ll see). You could also lose money. A lot of it.
Options, as we’re going to discuss them here, are not a long-term investment strategy. This is not where you put your kid’s college fund: this is an edge of your seat, smoking cigars, scream “BUY!!!!! SELLLLLL!!!!!” into one of those Bobby Brown headset things kind of deal.
I’m learning about stock options specifically because I want to gamble a bit with my money in an effort to make more of it. If that’s not for you, no problem.
Stock Options, Part 1: What are they, and why should I care?
So. What are stock options, anyway?
Let’s start with stocks.
Stocks, as most people know, are shares of a company. When you buy a piece of stock for 10$ in, say, Enemies List, you are buying an actual part of that company. As a publicly traded company, Enemies List would have to listen to the people that owned our stock, and the more stock you owned, the more influence you’d have.
This is important, because if Enemies List does poorly and loses value, your stock will be worth less. If you then wanted to sell your stock, you might only be able to find someone willing to buy it for 5$ a share, meaning you lost 50% of your initial investment. Likewise, if Enemies List did awesome, it’s price might rise to 20$ a share, and you could sell your stock and make some money.
Stock options aren’t actually stock at all. Instead, stock options are a promise – a contract – between two people. That contract states that one person is willing to buy, or sell, stock to the other person at a specific price, at a specific time.
Let’s look at an example (the numbers and such are simplified here).
Let’s say you think Enemies List is going to do really well next month. We’ve been growing steadily, and the trend of our stock price is upwards. Seems like a good investment!
However, you only have 10$ to invest, and Enemies List stock costs 100$ a share.You don’t have enough money to actually buy stock in EL. Bummer.
Instead of buying stock, however, you could buy a stock option. You look online and find one stock option that reads like this (when translated into plain english): “Whoever buys this contract agrees to buy one share of Enemies List at the price of 101$ a share one month from now. The cost to buy this contract is 10$.”
Due to your analysis, you’re pretty sure that Enemies List stock will be worth at least 200$ a share next month. That means that, if you had this contract when the price went up you could buy one share for 101$ (your contracted price) and turn around and immediately sell it for 200$ (the market price), making a tidy 89$ profit (the 99$ you make from the sale, minus the original 10$ for the stock option). You’ve spent 111$ on the contract and the stock, and made 200$, a 180% return on your investment.
What’s more, if you didn’t have the money to actually buy the stock for 101$ when your contract came up, you could sell the contract itself. If the price really goes up to 200$, people will want to buy your 101$ contract. They might pay you 80$ for it, meaning you would make a tidy 70$ profit (80$, minus your original 10$ for the option). You’ve spent 10$, and made 80$, an 800% return on investment.
Stock options thus give you two ways to make money: by buying and selling the stock as stated in the contract, and by selling the contract itself.
An option to buy stock at a certain price is called a call option. When you buy this kind of contract you’re essentially betting the stock price will go up within a certain amount of time. Call options give you the right, but not the obligation, to buy stock at a certain price on or before a certain date.
You can also buy a kind of option, called a put option, that bets the price of the stock will go down. Put options give you the right, but not the obligation, to sell shares of a stock at a certain price on or before a certain date.
What are the benefits of trading stock options?
Stock options have a few benefits that make them attractive to someone like me, with not a lot of money to invest.
1. There’s potential for a lot of profit. Stock options tend to be volatile, meaning that there’s potential for a very high return on investment (anywhere from 10 to 900%, in some cases).
2. Your risk is clear. Essentially, you know what you’re risking with stock options: the cost of the contract. If you spend 10$ to buy the contract, and the stock doesn’t do what you expected, the contract expires. You’re out the 10$, and that’s more or less it.
3. You don’t need a lot of money to start. Options allow you to profit from the rise or fall in the value of stock without actually owning that stock, and at a fraction of the price. Since making a lot of money in stock usually takes time and a high number of stock, stock options can be attractive to those without a lot of money who aren’t necessarily looking for a stable, long-term investment, but are instead looking to learn the market and make money in the short-term.
If this all seems pretty simple, it is…at least, at a basic level. Of course, there are complicating factors which make figuring out the actual worth of stock options more difficult.
Complicating Factors – and/or, Stock Lingo Makes Me Want To Put A Bullet in My Brain
Now, some caveats to the simple picture laid out above:
For one, stock options are also called derivatives. So. There you go.
Stock options give you control over 100 shares of stock. That means that if you used a stock option for buying stock at $7.10, you’re not going to spend $7.10, you’re going to spend $710 (the price of the option x 100 shares).
Not all stocks have stock options. There are various factors which determine whether a company can or should have options, but just know that you can’t buy stock options for every stock that exists.
The price you are contracted to buy or sell a stock at is called the strike price. For example, in the example above we bought a stock option on Enemies List for a strike price of 200$.
Stock options have time limits. Figuring out the impact of time on your option is one of the most complicated factors of the whole business. Remember: a stock option is a contract to buy or sell at a certain price on or before a certain date. Once that date passes, your stock option ceases to exist, just like your membership with Netflix might expire. This means that the value of stock options can change pretty rapidly once you get closer to their expiration date.
Stock options expire on the 3rd Friday of whatever month they expire in. For example, if you purchase a December call option, it expires on the 3rd Friday in December.
Those are the basics of stock options. Next time: how to read stock option reports and how to actually trade them
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