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Should I use options?

I am starting to get serious about investing in stocks and I have heard experts talking about using options to help insure your portfolio. What do they mean and should I be using options?

Options can be used to hedge your portfolio of shares against the risk of a sell-off but you have to know how to use options properly. As a buyer, you’re the holder of an option and the seller is called the writer.

A call option gives the holder the right, but not the obligation, to purchase the related share at a set price and within a set time period. On the other hand, a put option gives the holder the right, but not the obligation, to sell the share in question at a set price with a set period of time. The price you pay or receive is called the strike price.

On the other hand, call option writers (sellers) have a potential obligation to sell if the holder exercises the right. Put option writers (sellers) have a similar potential obligation to buy.

So what we’re talking about is a right to buy or sell a share and you pay a percentage of the share’s strike price to own this right. Smart traders who have made good money on a share, and who think it might go higher and therefore want to keep holding it, may take a put option which might be, say, 10 per cent below the current share price.

That means if the market sells off and the share in question slumps 20 per cent, by having this option the holder has limited the downside risk to only 10 per cent. If the share goes higher, the option would be allowed to expire, which means the holder loses the deposit but that’s the price of having insurance against a big sell-off.

How you use these options depends on you making some judgement calls. Some people use options for stocks they get tips on and this, once again, limits their exposure to losses. If the tip is a good one, the holder can exercise the option but if it’s a dud only the deposit on the option is lost.

I recommend a lot of homework and talk to a stockbroker making sure you ask every conceivable question you might have so you know exactly what you’re getting yourself into. By the way, there are fees involved in options as well, so make sure you know everything before you proceed.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Published on: Saturday, May 21, 2011

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