Options Education

The Power of Options

Many people have discovered the power of options. Their acceptance in everyday financial management is growing as more and more investors begin to see them as a nice complement for the modern investment portfolio. Options can become a very powerful tool in the hands of the educated investor, allowing investors - conservative and aggressive alike - to make money in any type of market environment.

The versatility of options allows them to be used in a wide range of investment strategies and for a variety of goals.

You can:

• Increase income against current stock holdings.
• Prepare to buy a stock at a lower price.
• Benefit from a stock price rise without incurring the cost of buying the stock outright.
• Make a monthly paycheck on stock that you own.

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 intended to reduce risk. For example, in the commodity markets, options are used to lock in fair or reasonable prices in a possibly volatile future.

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 options 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 Dealer's Association a chance to speak.

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 are a valuable investment tool. The options business survived the hearings and the SEC assumed regulatory authority under the Securities and Exchange Act of 1934. The SEC still regulates the options industry today.

Review - 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, and 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. 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 of stock by investing a smaller amount of money than he or she would in 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 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 climbs from $32 to $42 you would have a $1,000 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 $1,100. 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.

Strategy Breakdown

Options Investing Strategies

Buying Calls (Bull Market) and Buying Puts (Bear Market)

Buying calls and puts is considered the most aggressive of these strategies. They are exposed to market directional risk and are considered speculative. They may be referred to as directional trading plays. As powerful as they are only allocate a small portion of your portfolio to them. When taking on directional risk of this sort, follow the most stringent money management guidelines. They are referred to as being Long positions. By purchasing a Call you will be considered long a call option and will have the right to buy and/or benefit from a rise in the underlying stock. By purchasing a Put, even though you have the right to sell and/or benefit from a drop in the underlying stock, you will be considered long a put option. Their use is only recommend after one has gained significant experience and confidence in the market and is successful trading stocks.

Covered Calls (Neutral Market, Use to sell stock, Income) and LEAPS (Bull Market)

This is when you write a contract and sell it (sell a contract you do not own). These strategies can be considered a form of hedging. You will have the obligation side of the contract. By selling contracts you will be considered Short. By selling a call contract, you are giving someone the right to force you to sell the underlying asset. For Covered Calls you must own the underlying stock. Depending on your mindset you can use these strategies to buy stock or sell stock at agreed-upon levels, and in effect get paid to do so. LEAPS (Long-Term Equity Anticipation Securities) are long-term options (more than 9 months). They are considered more conservative in nature due to their longer time frame and have a similar risk profile as owning stock.

Advanced Strategy – Selling Naked Puts (Bull Market, Use to buy stock, Income)

This is when you write a contract and sell it (sell a contract you do not own). These strategies can be considered a form of hedging. You will have the obligation side of the contract. By selling contracts you will be considered Short. By Selling a Put contract, you are giving someone the right to force you to buy the stock. For naked puts you must have the financial resources to purchase the stock if it is put to you. Depending on your mindset you can use these strategies to buy stock or sell stock at agreed-upon levels, and in effect get paid to do so.

Purchasing Options

Now that you understand some of the basic language and concepts of options, let's discuss some things about buying options.

Buying call and put options is risky. They are not recommended for the beginning investor.

If you are going to use them you should:

• Use strict money management guidelines.
• Use the same entry rules and exit rules you would for trading stock.
• Decide if you want to use the leverage of options in a position based on your assessment of the trade.

Your primary concern for evaluating a possible option trade should be based on the price action of the underlying asset. As an option buyer you have the choice on what to do with that contract: sell it to someone else or exercise it. The best choice is almost always to sell it, but just in case let's find out what it means to exercise a contract.

Option Exercise

When you take advantage of the right granted by your option, it is known as exercise. If you exercise a call, you buy the stock at the option's strike price. If you exercise a put, you sell the stock at the option's strike price.

American Style Exercise options, which are the vast majority of options traded in the U.S., allow the holder of the option to exercise anytime before expiration. In contrast, holders of European Style Exercise options can only exercise during a specified period of time just prior to the options'expiration.

In both cases, expiration usually occurs on the Saturday following the third Friday of the month. However, because the exchanges are not open on Saturday, trading actually stops on the preceding Friday, and in the case of some index options, the expiration is actually on the 3rd Friday of the month.

You should also note that different brokerage firms have differing policies regarding the automatic exercise of options In-the-Money at expiration. Contact your brokerage to know how your brokerage handles expiration and margin requirements if you do not have adequate cash in your account to perform the exercise.