Page 419 - How to Make Money in Stocks Trilogy

Money Management 289

Shorting must be done in a margin account, so check with your broker to
see if you can borrow the stock you want to sell short. Also, if the stock pays
a dividend while you are short, you’ll have to pay the dividend to the person
who owned the stock you borrowed and sold. Lesson: don’t short big divi-
dend-paying stocks.
Short selling is treacherous even for professionals, and only the more able
and daring should give it a try. One last warning: don’t short an advancing
stock just because its price or the P/E ratio seems too high. You could be
taken to the cleaners.

What Are Options, and Should You Invest in Them?

Options are an investment vehicle where you purchase rights (contracts) to
buy (“call”) or sell (“put”) a stock, stock index, or commodity at a specified
price before a specified future time, known as the option expiration date.
Options are very speculative and involve substantially greater risks and price
volatility than common stocks. Therefore, most investors should not buy or
sell options. Winning investors should first learn how to minimize the
investment risks they take, not increase them. After a person has proved
that she is able to make money in common stocks and has sufficient invest-
ment understanding and actual experience, then the limited use of options
could be intelligently considered.
Options are like making “all or nothing” bets. If you buy a three-month
call option on McDonald’s, the premium you pay gives you the right to pur-
chase 100 shares of MCD at a certain price at any time during the next three
months. When you purchase calls, you expect the price of the stock to go up,
so if a stock is currently trading at $120, you might buy a call at $125. If the
stock rises to $150 after three months (and you have not sold your call
option), you can exercise it and pocket the $25 profit less the premium you
paid. Conversely, if three months go by and your stock is down and didn’t
perform as expected, you would not exercise the option; it expires worthless,
and you lose the premium you paid. As you might expect, puts are handled
in a similar manner, except that you’re making a bet that the price of the
stock will decrease instead of increase.
Limiting Your Risk When It Comes to Options
If you do consider options, you should definitely limit the percentage of
your total portfolio committed to them. A prudent limit might be no more
than 10% to 15%. You should also adopt a rule about where you intend to
cut and limit all of your losses. The percentage will naturally have to be
more than 8%, since options are much more volatile than stocks. If an