During the past 15 years, those who follow and invest in the stock market have been on an accelerated learning curve. Since 1987, we have gotten the largest one-day crash, the longest bull market in history and a painstaking bear market that hasn't yet left us.
Unfortunately, most investors are only aware of buying stocks and holding on for the long term. But now you might be asking what other options there are. Good question.
Almost all stocks moved sharply higher during the great bull market of the 1990s. As a result, most investors saw sharp gains in their portfolios. My, how things have changed. In March 2000, the
reached a high of 5132 before falling back to as low as 1108 -- a 78% decline. The Nasdaq has since recovered some of this ground. Nonetheless, this index would have to gain 15% per year for nearly 10 years to get back to its all-time high price.
We all know how to make money in bull markets, and we have some understanding of how to make money in bear markets. A stock trader can sell stock short to profit from the decline in stock prices. However, this requires a margin account and has unlimited risk and complicated rules. Profits can be made, but there are no strategies using stock alone to profit from a sideways market.
However, what if I told you there was a trading vehicle that allows for more leverage, little or no margin and can profit in any type of market?
I'm referring to the use of stock options. Now, the first thing that might have entered your mind is "high risk." As with any tool, it can be used wisely or unwisely, but if used appropriately, options can be a great boost to your trading success. I'll give you an idea of how they can be utilized.
Options have two uses -- one for speculation, the other for hedging. We all buy insurance to offset the cost of a total loss of an expensive item. If we have homeowner's insurance, we pay a small fee to protect us in case our house burns down.
Options can be used in a similar manner. At the beginning of the new millennium, many analysts and traders were starting to worry about the overvaluation of stocks, particularly those in the Internet sector. However, without the use of options, the only choice would have been to sell your stocks.
In hindsight, this would have been wise, but some analysts had been calling for a bear market since the mid-1990s. Those who knew about options could have used this vehicle to hedge their portfolios, resulting in smaller or, in some cases, no losses. This is because option contracts control a large amount of stock for a small premium. In the case of protecting a long portfolio, an investor could purchase put options, which increase in value as the stock depreciates. In essence, by purchasing put options, investors would have been insuring their portfolios from the bear market that ensued.
The other use for options is to garner profits, which many call speculation. However, the versatility of options allows a trader to achieve large profits with very little risk. Nonetheless, the industry gets a bad name because of the many traders who let greed control their trading, resulting in large losses. Besides profiting from gains in stocks, options allow traders to garner profits even when a stock moves sideways. Options also allow traders to profit from declining stock prices without the rules and large margin necessary when shorting stocks.
A call option gives a buyer the right, but not the obligation, to buy a stock at a particular price over a given amount of time. If the stock rises in value, I could then exercise my option or sell it for a higher price to someone else. The whole process is very easy because there are options markets that are liquid and nearly as easy to buy and sell in as the regular stock market.
Though the options market provides some great advantages for traders, it isn't for everyone. Options, like any profitable endeavor, take time to learn and understand. However, for those who are willing to put in the time and effort, options can provide profits that easily surpass long-term stock investing.
By Jody Osborne, senior staff writer and options strategist at