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Myths About Investing With Options

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Debunking the myths about investing with options.

I once heard an interesting distinction made between investing and gambling: If you can reasonably expect to win on average, it's investing. If not, it's gambling.

Options have a reputation as the gambling den of the investing world; most view them as vehicles for high-risk speculation. This reputation doesn't change the fact that, when used properly, options can make tremendous contributions to your portfolio.

At Morningstar, our mission is to help you use options to invest, not to gamble. The key to success with all investing is only to invest when you have an edge-an insight that gives the investment a positive expected return. This applies to options investments just like any other investment. Some investments may be risky, or may have a short time horizon, but option investors are willing to take those risks if they have an edge through fundamental research, because they know the strategy will win over the long run.

The number-one objective of this guide is to help you develop an intuitive understanding of stock options. By intuitive understanding, I do not mean a "gut feel" or a "trader's instinct." That's hokum. I mean a fundamentally sound understanding of the theory and practical use of stock options. Although stock options can seem intimidating at first blush, they really are understandable-I promise!-and they can enable you to generate profits in bull or bear markets.

In addition, I think the insights that come from understanding options can (and will!) improve your stock-investing skills as well.

I've distilled this guide down to 10 key principles. Once you have developed a strong grounding in the use of options through these 10 principles, you'll be able to see how analysis of the fundamentals of the underlying company, and therefore the future of the stock price, can be transferred to an investing edge in the options market.

Sure, there are myriad books on the basics of stock options, and many of them do a good job explaining the mechanics of options in a traditional theoretical framework. In this guide, however, I instill a practical fundamental, intuitive understanding of options, augmented by some simple examples, rather than plowing through detailed numbers and models.

It's the approach that you'd expect from Morningstar.

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