Wednesday, 9th June 2010

Introduction to Options

Written by George Traganidas Topics: Options, Wealth Building

Introduction to Options

Why Options?

Options are excellent tools for generating income, protecting profits, hedging, and, ultimately, earning outsized gains. They can generate returns in flat markets, cushion the blow of down markets, and be outstanding performers in decent markets. Whatever your investment goals, options can be a powerful addition to your portfolio, used to hedge, to short, to produce income, and to obtain better buy and sell prices.

What Are Options?

Stock options formally debuted on the Chicago Board Options Exchange in 1973, although option contracts (the right to buy or sell something in the future) have been around for thousands of years. An option gives the holder the right, but not the obligation, to buy or sell an underlying stock at a set price (the strike price) by a set date (the expiration date). The option contract allows you to profit if a stock moves in your favor before the contract expires. Not all stocks have options, only those with enough interest and volume. There are only two types of options: calls and puts. A call appreciates when the underlying stock rises, so you buy a call if you are bullish on that company. A put appreciates when a stock declines. You buy a put if you believe a stock will fall or to hedge a stock that you already own.

Strategy Why
Buy Calls When you believe a stock will rise significantly over time and you want to leverage your returns or minimize capital at risk
Buy Puts To short a position, or to hedge or protect a current long holding
Sell Covered Calls To earn income on shares you already own while waiting for your desired sell price
Sell Puts To get paid while waiting for a lower share price (your desired buy price) on a stock you would be happy to buy

Buying Calls

Investors often buy call options rather than buying a stock outright to obtain leverage and potentially increase returns several-fold. Call options work as “controlled” leverage, enhancing your possible returns while limiting your potential losses to only what you invest. Because each option contract represents 100 shares of stock, an investor can control many shares of stock without putting a lot of capital at risk.

Imagine that a stock that you know well has declined in value and now trades at $27 per share. You believe the shares will rebound in the coming months or year. The market offers $30 call options on the stock that expire in 18 months for $1.50 per share. Therefore, 10 contracts, representing 1,000 shares of the stock, will cost you $1,500 plus commissions. This option contract gives you, its owner, the right to buy 1,000 shares of the stock at $30 any time before expiration. A few things could happen here:

a) If your stock starts to rise again, your options will increase in value, too. Suppose the stock recovers all the way to $32 after a few months. Your option’s value would likely at least double to $3 or higher per contract. You’ve made 100% in a few months. If you had simply bought the stock, you’d only be up 18.5%.

b) If your stock continues its decline. Even 18 months later, it’s below $20, so your options expire worthless (unless you sold them at some point along the way to recoup part of your investment).

Buying Puts

You buy put options when you believe that the underlying stock will decline in value. Buying puts is an excellent tool for betting against highly priced or troubled stocks, or even entire sectors. With put buying, your risk is again limited to the amount that you invest in stark comparison to traditional short selling, where your potential losses are unlimited. Aside from betting against a position with puts, you may also buy puts to protect an important position in your portfolio, one that you do not want to sell yet for any number of reasons. When a stock being protected (or hedged) in this way declines for a while, the puts will increase in value, smoothing out returns.

Selling Covered Calls

“Covered” simply means that you own the underlying stock at the same time. Writing covered calls is one of the most conservative options strategies available. In fact, most retirement accounts allow you to write covered calls. They’re generally used to generate income on stock positions while waiting for a higher share price at which to sell the stock.

Suppose you own 1,000 shares of a stable, blue-chip stock. It’s trading at $56, but you think it is fairly valued around $60 and you would be happy to sell at that price. So you write $60 call options on the stock expiring a few months ahead, and you get paid up front to do so. A few things could happen here:

a) If the stock does not exceed $60 by your option’s expiration, you keep your shares and you’ve made money on the call options. You could then write more calls if you wanted to.

b) If the stock is above $60 by expiration and you haven’t closed out your call option contract, you’d sell your stock at $60 via the options.

Write covered calls when:

  • You would sell a stock that you own at a higher price, and you’re not worried about it declining too much in the meantime.
  • You believe a stock you own is going to stagnate for a while, but you don’t want to sell it right now. Write calls to make the stagnation more profitable.
  • You want to cushion a stock that is in decline, but that you’re not ready to sell yet. Tread carefully here so you don’t get sold out at too low a price.

When you write covered calls, you must be prepared to give up your shares at the strike price. Approximately 80% to 90% of options are not exercised until expiration, but they can be exercised early, so the call writer has to be prepared to deliver the shares at any moment.
That means that if the $56 stock in the example above suddenly soars to $70, you’d still have to sell at $60. This is the biggest downside to covered calls — lost potential if a stock price rises. The other risk is that a stock may fall sharply after hovering around your desired sell price for a while, forcing you to wait longer for your sell price.

Selling Puts

Put options are an excellent way to potentially buy a stock at your desired, lower share price and get paid an option premium while waiting for that price, whether it arrives or not.
A stock is trading at $39 and your analysis suggests that you should not buy it above $35. The $35 put options expiring four months out are paying $3 per share. You “sell to open” the put contracts and get paid $3 per share to make the trade, giving you a potential net purchase price of $32 before commissions. A few things could happen here:

a) If the stock stays above your $35 strike price; the options you sold would expire. You didn’t get to buy the stock at the price you wanted, but at least you made money on the options you sold.

b) If the stock falls below $35 by expiration. In this situation, your broker would automatically buy the stock for your account, giving you a start price of $32 before commissions.

Writing puts on stocks you know well and want to own at lower prices can be an excellent tool for income and for securing lower buy prices, but you must be prepared to buy the stock should it fall below your strike price. At all times, you must maintain the cash or margin to buy shares if they are put to you. It’s important that you only write puts on stocks that you understand well and will be happy and ready to buy at the prices you’re targeting. The risks of writing puts include the fact that the stock could soar away without you. In many cases, it’s better to just buy a great stock once you’ve found it. The other risk, of course, is that a stock falls sharply and you’re stuck owning it. The biggest risk with selling puts, as with all options, is when investors rely on margin instead of cash. That can quickly wipe out a portfolio.

Call Option Put Option
Option buyer The right, but not obligation, to buy a stock at a set price (the strike price); calls appreciate as the stock rises The right, but not obligation, to sell a stock at a set price (the strike price); puts appreciate as the stock falls
Option writer The obligation to sell a stock at the strike price; must hold the stock in the account. This is called a “covered” position The obligation to buy a stock at the strike price; must have the buying power at the ready (preferably in cash) in case the stock declines
Option buyer Believes the underlying stock will rise Believes the underlying stock will fall
Option writer If the stock rises, is ready to sell her existing shares at the strike price, keeping the premium paid for writing the option If the stock falls, is ready to buy it at the strike price, keeping the premium received for writing the option

Follow the practical way,
George Traganidas

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