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I get questions all the time from people who want to understand options better. Here is an excerpt from my new report on the basics of options.

By Chris Rowe October 27, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

I get questions all the time from people who want to understand options better.

Some of the questions are complex ... others have to do with our specific Trend Rider recommendations ... but many of them point to one thing: People really need to take a step back and make sure they understand the basics of options.

I can't emphasize enough the importance of understanding the basics about options. If you start trading options without a solid fundamental understanding of how they work, you're playing a dangerous game.

One of the things I try to do at The Trend Rider is to educate my members the very best I can. With each trade recommendation, I try to explain the logic behind my strategy versus other strategies.

For example, this very week on Monday, one of our portfolio companies was taken over, giving us unrealized profits of roughly 60%.

Now don't get me wrong - I'll take profits of 60% any single day of the week, and twice on Sunday. But the profits could have been over 100% if I had not hedged our position earlier with what's called a calendar spread.

From a distance, some people may have been disappointed given what happened that they chose to hedge their trade. Fair enough - profits of 100% are always better than profits of 60%.

But by saying that, what they fail to understand is the fundamental relationship between risk and reward.

One of the very first rules in finance is the greater the reward, the greater the potential risk.

So, while creating a calendar spread we definitely lowered our potential upside - we also reduced our risk.

Most people who make their living by trading are keenly aware of this relationship, as am I.

Learning how to trade intelligently - whether it's options, stocks or currencies - requires years of study, practice and patience. Hopefully, all Trend Rider members can say that they are getting a lesson in all three areas with the service.

But where do you start if you're interested in learning about options?

I'm just putting the finishing touches on a new report that I'll be sending out to my Trend Rider members very soon.

The title of this new report is "Options Made Simple." It's designed with the simple goal of making sure everyone using the Trend Rider service has the same basic understanding of how to use options for both aggressive profit plays and conservative risk management.

Below is a small excerpt from the report for you. Enjoy ...

Calls and Puts in Language We All Understand ...

How Buying a Call is Like Buying a House

Some people are confused by options, but the reality is that people have been using options for ages in the form of contracts such as real estate and auto insurance.

One way of looking at a call option is drawing a comparison to a contract to buy a house.

If I were considering purchasing a house, I would agree on the purchase price before actually purchasing the house.

Let's say in this example that I would put down a deposit of $5,000.00, and I would draw up a contract, guaranteeing that I could purchase the house at the agreed upon price.

(When I put money down to buy a call option, I also receive a contract, guaranteeing that I can buy a stock at a fixed price.)

But let's say that a catastrophic event sent real estate prices down. I could find a way to back out of the deal and choose not to buy the house at that price, but I would lose my $5,000.00 deposit.

If the house went down in value by $100,000.00 I wouldn't worry too much about backing out and losing a $5,000.00 deposit. (Good thing I didn't actually own the house, or I would be down $100,000.00!)

But if the value of the house suddenly went up by $100,000.00, then the contract, which guarantees me that purchase price that we agreed on, suddenly becomes much more valuable. (I'd sure hate to misplace that piece of paper!)

How Buying a Put Option is Like Buying Insurance

When you purchase an insurance policy, you have purchased a contract that you pay a "premium" for. The insurance company isn't giving you anything you can hold in your hand … just a promise to fulfill a specific obligation in the future.

If you've paid for an auto insurance policy, and then you crash the family car, the insurance company is obligated to take whatever action necessary to return the car to its prior condition.

As a matter of fact, a put option is commonly used as an insurance policy on a stock position.

For instance, let's say you own 100 shares of stock in H&R Block, which was trading at $23.00, and you absolutely loved the stock.

I mean, you believed with every fiber of your being that the stock was going to trade to $40 this year. But they were going to announce earnings in a week, and you heard a silly rumor that the earnings would be terrible, which would send the stock crashing down!

A smart choice would be to simply hold on to your stock, but at the same time buy a put option with a strike price of $22.50. That would give you the right to sell your stock at $22.50 if you chose to do so.

This way, even if the H&R Block stock traded down to $10.00 per share, it's okay because you bought insurance on your stock (in the form of a put option) that says that you can sell the stock at $22.50.

That's a very simple example of how you can use options to protect yourself against losses.

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