How Do Stock Swap Options Work?

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Stock swaps are traded directly between individuals, banks or large corporate investors, and they are promises to act in a certain way if a stock achieves a certain status. Find out why stock swaps can be very risky with help from a personal asset manager in this free video on investing in the stock market and money management.

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Video Transcript

Hello. I'm Roger Groh with Groh Asset Management. Today we're here to talk about stock swaps. What they are, how they work and how you might be able to use them. Well, you may very well as an individual investor know about stock options. Those are ones that traditionally you buy, through a brokerage firm in the country where you are. And if the price of the stock moves up or down, depending on what the option said, most frequently you lost money and then occasionally you made money. But by far, the biggest volume in options, is not traded through any brokerage firm. They're traded directly, between individuals, banks, or large corporate investors. These are called swaps, and what they are, are promises from one group to another, saying, I will do this if your stock does that. They offer much more risk traditionally, than the options that you would buy, say at Citibank or Charles Schwab. Because they are tweaked quite a bit with leverage and other items in them, which is fine, because the corporate investors are very sophisticated in theory, and are capable of handling the losses, that more frequently come about. Now, why would you use them? Well, it may be a case where you're trying to delay income tax consequences until the next year. Or it may be a case where you're trying to lock in yield on a very large position that you have in a mutual fund. Or it may be a case where you're trying to generate cash in a position that you own, that you own within a mutual fund, as a mutual fund manager. And you're giving somebody else to right to buy those shares away at some price in the future. So those are examples. A lot more risks in swaps, it's an unregulated market. If you've been listening to the financial news at all, then you've listened to the fiasco's at Bear-Stearns and Merrill-Lynch and many of the other banks. That was caused primarily by swaps. Where the pricing in the swaps disappeared, which diminished the balance sheet value, which caused companies then to hold and horde all of the cash that they had, which dried up lending, which meant if you went to buy a car or buy a house, nobody was going to lend you money which puts us in the position we are today, which is recession. I'm Roger Groh and this is a little bit about swaps and thank you for spending a few minutes with me.

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