Options Education

Intro to Options

Every day, options traders around the world profit from the rise and fall of equity markets. Even when the general markets are down, there is profit to be made if you simply know how to make options work for you. Options can become very powerful tools in the hands of the educated investor. They allow investors to make money regardless of overall market conditions, with strategies so diverse traders can tailor their approach to be conservative, to protect or "hedge" their positions, or even be aggressive with money they can afford to lose.

Options are so versatile they can be used in a wide range of investment strategies and goals.

For Example

• Options may be used to buy stock at a lower price than "retail".
• Options allow traders to participate in the ups and downs of a stock's price without even owning the stock.
• By executing certain strategies, you can potentially make a monthly income on stock that you currently own.
• You can protect a stock or even make money when the market goes down.

You have probably heard of the inherent risks in options and have been told they are primarily used for speculation. In reality, options can be very conservative or very aggressive, depending on the forecast you have for the stock and the strategy you want to employ.

In fact, some of the earliest option applications were used to reduce risk rather than increase it. For example, in the commodity markets, options are used to lock in fair or reasonable prices in a potentially volatile future.

Background of an Option (Historical Example)

You may have already heard of the Dutch tulip mania in the 1600's. When tulips gained popularity with those of royalty, the general demand increased for all types of bulbs. Tulips became a status symbol and tulip bulb prices rose dramatically. As bulb prices increased, Dutch growers and dealers began to trade tulip bulb options to lock in prices and insure profits. As public interest grew, greater numbers of people speculated on future price increases. In the beginning, this proved to be profitable. This situation only caused the speculation to increase and tulip bulb prices continued to soar even higher.

The bubble soon burst and as prices dropped, the buying frenzy became a selling panic. People lost their homes and their livelihoods, banks failed, and fortunes were lost. Although greed, reckless speculation, and the use of borrowed funds to invest caused the financial collapse, people blamed options. This was because tulip options were responsible for enabling people to speculate with small amounts of money and large amounts of leverage.

We should learn the lesson that leverage can work against a trader just as easily as it can work in his or her favor.

In America during the 1920's, the option market was unregulated and there were many abuses by underground option pools. During the congressional hearings to establish an oversight committee, which eventually became the Securities and Exchange Commission, the initial reaction was to make all options trading illegal. However, Congress gave the Put and Call Dealers' Association a chance to speak out.

The Association explained the difference between options where put-call dealers deal openly for a consideration and manipulative options secretly given for no fee. In other words, there were both good and bad options, but the lack of knowledge about the proper use of options and the heightened public awareness of option pools led many in Congress to conclude that all options were speculative.

The proposed bill read: "not knowing the difference between good and bad options, for the matter of convenience, we strike them all out." Members of the committee also expressed concern about the number of options that expire worthless. It was stated: "If only 12 ½ percent are exercised, then the other 87 ½ percent of the people who bought options have thrown money away?" The reply was, "No sir. If you insured your house against fire and it didn't burn down you would not say that you had thrown away your insurance premium." The committee initially saw expired options solely as a monetary loss rather that a means of insurance against potential loss.

This argument convinced the committee that options have economic value and when properly used, options can be valuable investment tools. The options business survived the hearings and the SEC assumed regulating authority under the Securities and Exchange Act of 1934. The SEC still regulates the options industry today.

What is an Option?

An option is a contract that derives its value from an underlying asset. That contract either gives the owner the right to buy the asset (call option) or the right to sell the asset (put option) at a predetermined price and within some predetermined time frame.

The key idea here is that the owner of an option has a right, not an obligation. If the owner of the option does not exercise this right before the predetermined time, then the option and the opportunity to exercise it cease to exist, the option expires.

Seller (Writer)

On the other hand, the seller (writer) of an option is obligated to fulfill the obligations (requirements) of the contract if the option is exercised.

In the case of a call option on stock, the seller (writer) has given someone the right to buy the underlying asset. The seller of the call option will be obligated to sell the stock to the call option owner if the option is exercised. The owner of the options literally has the right to CALL the stock from you.

With a put option on a stock, the seller of the put option has given the right to sell that stock to another party. The seller of the put option is therefore obligated to buy the stock from the put option owner if the option is exercised. The owner of the options literally has the right to PUT the stock to you.

Option Examples

An option is a derivative. It derives or gets its value from an underlying asset. We are already familiar with them. Did you know that you are using a form of options as part of your daily life? Have you purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills? Do you pay a premium for your house, auto, and medical insurance? Then you have purchased a type of option. The fact is, options are a part of our everyday life, and have valuable application in our trading and investing.

Auto insurance, health insurance, and homeowner's insurance are all examples of put options. These options transfer the risk of loss from the owner of an asset to the writer (seller) of the put. Insurance companies are basically put option dealers.

Leverage

Leverage is the term used to describe the profit or loss potential when a small amount of money controls a large amount of money. The owner of one call option has the upside potential of 100 shares by investing a smaller amount of money rather than purchasing the stock outright. If there is a 10% rise in the stock, the option can double in value.

A word of caution: leverage also increases our risk. A 10% decline in the stock can result in the total loss of what we paid for an option.

Example

Purchase100 shares stock @ $32 for a cost of $3,200.00. If the stock rises from $32 to $42 you would have a $1000 gain or a 31% increase.
OR
Control 100 shares of stock by purchasing the option at a premium of $3 per share for a cost of $300 (1 contract x 100 shares x $3 premium = $300). If the option premium rose from $3 to $11, the original cost was $300 and it is now worth $1100. You have an $800 profit, but a 266% return!

When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar profit. But your option purchase will have a significantly higher percentage return.

Diversification of Options

• The possible payoff of options can make them very appealing – even seductive – for many investors.
• Those potential returns come from leverage.
• That leverage can also bring greater risk.

A ten percent increase in the underlying asset can potentially double your money in the options market. On the other hand, a ten percent loss in the underlying asset and you could go broke. Too many amateur investors or beginning traders do not take enough time to think about the potential downside before jumping in with leverage.

In the end it is all about control and choice. By having knowledge of options we are no longer limited to the buy and hope strategy. We can now make money in any type of market situation. We can be very aggressive or we can be conservative depending on our investing personality and objectives. There are several strategies you can implement with options. They can be broken down into basically two groups: trading strategies and investing strategies. Since the primary focus here will be on investing strategies, let's take a look at the breakdowns to get the big picture.