A call is a type of option contract that gives the owner the right to buy a stock at a certain fixed price within a specified timeframe.
Why It's Important
As I discussed in last week's word, Options, they are a good way to hedge against a downturn in the market if used correctly. Let's take an example:
Let's say a stock trades at $100 per share, and I think it's going to go up pretty soon. I could potentially buy 100 shares of stock, paying $10,000 OR I could buy a call option that would give you the right to pay $110 per share for stock any time in the next two months. My buy in for the option is typically $1-$2 per share. So, I would pay $200 for that right at the high end. This is a sunk cost (I'm not getting it back regardless of what happens).
If I'm right and the stock goes up to $130 per share by the time the option expires, then I can excercise my option and purchase the stock at $110 therefore making a profit of $20 per share even if I sold them right after purchase.
The weakness of the call option is that if the stock only goes up a little, the option's value can go down. For instance, if the stock goes up to $105 per share, I wouldn't excerise my option and take the loss of my $175 buy in (sunk cost, remember).
On the flip side, this could work out great if I am completely wrong! Let's say the same stock now trades at $90 per share. Instead of taking a loss of $2,000 (110 - 90 x 100), I can just take my $175 loss and be on my way.
There are pros and cons to trading options. As always, do your research!
An option is a contract that gives the buyer the right, not the obligation, to buy or sell an asset at a certain price in the future.
Why It's Important
Options play an important part in some portfolios as a way to hedge (arbitrage) against loss. Although you can purchase options on bonds, stocks, and futures, stocks are typically the go-to. So, how does it work? Let's use a simplified example.
Let's say I think Apple is going to go up. I pay a fee (or premium) to purchase a call (buy) option for the current price. This means as Apple climbs in value I can exercise my call option to get the stock for a lower price. But, let's say the stock goes down, I can opt to not exercise my option and just let it expire. If that's the case, I only lose the premium that I paid for it.
On the other side of the table, if I were the person selling the contract, I would lose money as the price went up and gain money if the buyer decided not to exercise it. Beware! If you are the person selling the contracts, you have to make sure you have enough shares to cover the order in case it gets exercised otherwise it could spell trouble.
Options are pretty risky and I don't recommend trading them unless you have a full understanding of what's going on. This topic will be discussed at my Investing: DIY - Advanced Topics event this weekend.
Adjusted Gross Income or AGI is gross income minus adjustments to income for tax purposes
Why It's Important
AGI is the portion of your income that you are taxed on. I think the best way to explain this term is to provide an example.
Let's say your salary is $50,000 a year. Because you are awesome, you contribute 5% of your salary to a 401k. To keep is simple, we will leave the salary deductions there (in real life, you will probably also deduct medical, dental, and vision benefits as well). 5% of $50,000 = $2,500 so instead of being taxed on your full (gross) salary of $50,000, you would only be taxed on $47,500 of it. $47,500 is your Adjusted Gross Income.
This is why participating in company sponsored benefits plans (like medical, 401k, HSAs, etc.) are so important. It effectively lowers your tax bill. It is important to note that in order for your gross income to get adjusted, the benefit has to come out PRE-TAX. Otherwise, it will not have an effect. Once you arrive at your AGI, you multiply by the tax rates to get your tax liability. We will discuss that next week!