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How to Know Your Options

Using Options Trading to turn small investments into large profits.

To most investors, volatility is a four-letter word! Of course, we love it when the market goes up, but give us just one down day and we begin to panic, envisioning all our worldly assets going down the drain.

But there is one category of investing that most investors often ignore, an investing technique that can help smooth the market’s volatility—and, at the same time, offer you an opportunity to profit during those up—and down—periods. That technique is Options investing.

Now, before you go back to burying your head beneath your pillows at the mention of this topic, let me just say this: Options are not for everyone, but if you hear me out, you may just find that options might be just the investment you need to boost your portfolio returns.

Options provide a chance to turn small investments into large profits by employing simple leverage—limiting your risk yet offering almost unlimited gains.

What’s more—because you can limit your risk, investing in options can actually be less risky than buying stocks.

So, let’s take the mystery right out of options and begin with some simple definitions.

Two Primary Types of Options

An option gives you the right—not the obligation—to participate in a future transaction on some underlying security. There are basically two types of options:

Call options give you the right to buy an investment at a predetermined price and are designed to profit from rising values. The downside is this: If you’re wrong—and the price of the underlying shares goes down instead of up—you lose the money you paid for the option. But the good news is: you have no obligation or liability beyond your initial investment. However, if you’re right and the price of the underlying shares rise, you are in a position to make a profit. This, in effect, leverages a very small amount of money that could turn into a large sum.

Put options give you the right to sell an investment at a predetermined price in order to profit from falling values. Think of them as working in reverse from call options. If the underlying shares decline, as you expected, you have the opportunity to profit from that decline. But if the price of the underlying shares unexpectedly rises, then your option just becomes worthless and you have lost only the price you paid for the option.

If there is no profit, you just let your option expire worthless. The profit potential is virtually unlimited, because you choose when—at what price level of the underlying stock—to exercise the option. But, most importantly, your potential loss is always absolutely limited to the amount you invest—not a penny more.

You can purchase most call and put options in large quantities. They’re traded on regulated exchanges, with low commissions and tremendous potential. In addition to individual stocks, you can also buy options on stock indexes—including the Dow Jones Industrial Average, the S&P 500, and the NASDAQ 100.

Before we get into examples, let’s define a few more terms:

I mentioned exercise price a moment ago. Another name for it is strike price. And it is the specified price on an options contract at which the contract may be exercised, or simply the price at which the option lets you buy or sell the underlying stock or stock index.

For example, a call option on XYZ stock with a strike price of 70 gives you the right to buy 100 shares of XYZ at a price of $70. Similarly, a put option on XYZ with a strike price of 70 gives you the right to sell 100 shares at $70.

The strike price is fixed in the options contract—for the life of the option—no matter what happens to the actual price of the underlying stock. The strike price is crucial, as it sets the risk and reward potential of an options trade. Risk and reward (along with the cost of the option) can be adjusted by choosing among a wide range of strike prices.

The expiration date is when the option expires. As with the strike price, traders can adjust their risk/reward and the cost of the option itself by selecting a different expiration date. All options expire on the third Friday of the named expiration month. Therefore, a Jan 20 call option would expire on the 3rd Friday of January (unless Friday is a holiday, then the expiration date is the Thursday before). The 20 refers to the strike price; in this case, $20.

The premium is the price you pay for the option. An expensive option has a high premium; a cheap one has a low premium. The price, or premium, of an option is usually quoted per underlying share. However, a stock option contract controls 100 shares of the underlying stock. For example, an option quoted at $2 is equal to a value of $200 for the contract ($2 times 100 shares).

A few more terms you will frequently hear when discussing options:

With a call option, at the money means the market price of the underlying shares is equal to the option’s strike price. Consequently, you are in a money neutral position—no profit or loss. If your options are in the money, the price of the underlying shares has surpassed the strike price—a potential profit situation. If they are out of the money, the price of the underlying shares is now lower than the strike price, so you no longer are holding a profitable option contract.

For example, you think the shares of XYZ Company are going up, and you want to take advantage of that rise without purchasing the shares themselves. Instead, you buy a Jul 20 call option, for $5. That allows you to buy 100 shares of XYZ at a strike price of $20, through the third Friday of July—no matter how low or high the shares trade. Of course, if they go lower, you wouldn’t want to exercise the option. But… if those shares are trading above $20 by that date, you are in the money! Let’s say they are trading at $30 by the date of expiration. So, you buy them at $20 ($20 x 100 shares = $2,000), sell them at $40 ($40 x 100 shares = $4,000), deduct the $5 you paid for the option ($5 x 100 shares = $500), and you have a profit of:

$4,000 - 2,000 – 500 = $1,500 = Your Profit

Of course, if the share price never gets to $20 (out of the money), you’ve spent $500 on a worthless options contract. And that is your total downside, even if the price of the underlying shares goes south of their original price. If, instead, you had purchased the actual shares, any rise past the original purchase price would be your profit (less commissions), but if the shares declined past that price, you could be holding a much larger loss than the $500 you would have spent by purchasing a worthless call option.

How Options are Priced

Anyone interested in trading options needs to be familiar with how options are priced and why the premium changes.

The option price, or premium, consists of two primary elements:

Intrinsic Value is simply whether the option is in the money or out of the money, terms I defined earlier. Intrinsic value is the relationship between the option’s exercise or strike price and the current price of the underlying security. Generally, an option that you can make money on now (in the money) will have a higher premium than one that is currently out of the money.

Time value is the amount of money that you are willing to pay for the option over and above the intrinsic value, prior to its expiration date. You might pay this if you thought the value of the option would increase because of a favorable change in the price of the underlying security. Generally, the longer the time period before the expiration date, the greater the time value (as you have more time for the price of the shares to increase or decrease, depending on the type of option you purchased).

Additionally, there are two more factors that influence the premium:

Volatility of the underlying security. Difficult to quantify, but very often significant, the volatility, or uncertainty in the price of the underlying security, will make the option premium rise, as investors who expect fluctuations in the share price demand to be paid for that risk or uncertainty.

Dividends and risk-free interest rate. Not generally a major influence on premium prices, but this ‘cost of carry’ is an opportunity cost, or a return that you may be passing up by not investing in alternative investments like Treasury Bills or dividend-paying stocks.

Option Strategies

Now, let’s talk some options strategies. In my ‘in the money’ definition, I gave you an example of buying a call option, the right to purchase 100 shares of a stock—an option you would purchase if you were bullish on the underlying stock.

Next, let’s look at buying a put option, the right to sell 100 shares of a stock—an option you would purchase if you were bearish on the underlying stock. Here’s how it works:

Let’s take our earlier call option example and reverse it. Now you buy a Jul 20 put option, for $5, so you pay a premium of $500 ($5 x 100 shares). If the shares fall below $20 by the third Friday of July (the option’s expiration date), you are ‘in the money’ and if you are far enough in the money to recover your initial $500 outlay + some, you would want to exercise your option.

Let’s say the shares have fallen to $10. You then buy them for $1,000 ($10 x 100), then sell them for $2,000 ($20 x 100), deduct your initial $500 outlay, and your profit is: $500, or $2,000 - $1,000 - $500 = $500 = Your Profit

Buying calls and puts are the most popular option strategies and can bring substantial profits, even to novice options traders. But there are scores of additional options strategies being utilized daily in the markets—many of which are extremely complex and should be plied by only the most experienced of traders. Consequently, I’ll leave their exploration to you, but caution you not to try for the home runs before you learn the basics through trial and error—and hopefully, profitable experiments.

There is one more options strategy that has caught on with the masses that I want to tell you about. It’s called covered call writing.

In a covered call, you sell the right to buy stock that you already own. For example, you purchase 100 shares of stock for $15 a share. Right away, you write a covered call option at a strike price of $20, for a premium of $2. You immediately earn $200 ($2 x 100).

If the shares don’t go above $20 before the expiration date, the option buyer doesn’t exercise his option, and you have netted a cool $200. Of course, if the share price declines below the initial $15 you paid, you are sitting with a loss, if you continue to hold them.

However, if the share price zooms up to $30, your option buyer is going to exercise his right to buy them, and he—instead of you—is going to reap the reward of that $10 per share climb (minus the $200 he paid to you for the option). This would be your downside, or opportunity cost. But you’ve still earned the $200 premium, so you can’t cry too much.

Covered call writing has become very popular, but it is not the risk-free strategy many advisors often tout. Remember, you own the shares, so you are still subject to the risk of those shares declining below your original purchase price.

I hope that you now feel a little more comfortable with options and can at least see their potential for adding a little oomph to your portfolio. I encourage you to learn more and would recommend that you visit these websites to further your education:

Chicago Board of Exchange (CBOE):