Is Options Trading Right For Me?
The most common perception of options trading is high risk, high reward trading, similar to gambling at Vegas, with worse odds. Because people do not understand options, and because the media tends to use words like wild and risky when describing options investing, the thought of actually investing in options creates fear and concern.
Let’s try to demystify some of the information about options so that we can help determine if options trading is right for you.
First, let’s define what an option is. An option is the right, but not the obligation to either buy or sell a stock for a given price before a given time.
There are two basic types of options, calls and puts. All other options trading strategies are simply extensions of calls and puts.
Call: A call is the right, but not the obligation to buy a stock at a given price before a given time. The buyer of a call is usually expecting the stock to rise.
A call is usually described in shorthand, such as what is below:
MSFT APR 25 CALL
This describes a call which gives the owner the right to buy Microsoft at $25.00 called the strike price, before the expiration date in April. Expiration dates are always the third Friday of a given month, so in this case, the owner would have the right, but not the obligation, to buy Microsoft for $25.00 before April 19, 2006.
Options are traded in contracts. A contract is 100 shares of the given, or underlying stock, but they are priced on a per/share basis. So, in our example above, if the contract price was $0.75, then you could pay $75.00 for the opportunity to pay $2,500 for 100 shares of Microsoft stock before April 19, 2006.
If Microsoft is at $27.50 on April 19, then you can exercise your right to purchase granted by owning the call, called exercising an option, to buy Microsoft for $25.00 and immediately sell the stock for $27.50. In reality, the way that this happens is that, unless you specify that you wish to purchase the stock, you will get $2.50 for each share, or $250 for the contract placed into your account.
If Microsoft is at $22.50 on April 19, then it does not make sense to pay $25.00 for shares of Microsoft. You will simply let your options hit the end date without being exercised. This is called letting an option expire.
Put: A put is the right, but not the obligation to sell a stock for a given price at a given time. The buyer of a put is usually expecting the stock to drop.
A put is usually described in shorthand, such as what is written below:
MSFT APR 25 PUT
This describes a put which gives the owner the right, but not the obligation to sell Microsoft at $25.00 before the expiration date in April, in this case, April 19, 2006. This contract would give the owner the right to sell 100 shares of Microsoft at $25.00, or for $2,500 total.
In our example above, if the contract price was $0.75, then you could pay $75.00 for the opportunity to pay $2,500 for 100 shares of Microsoft stock before April 19, 2006.
If Microsoft is at $27.50 on April 19, it will make no sense to buy 100 shares of Microsoft at $27.50 only to sell them at $25.00. So, you will let your option expire.
If Microsoft is at $22.50 on April 19, then you would buy 100 shares of Microsoft and exercise your put and sell those shares at $25.00. In reality, the way that this happens is that, unless you specify that you want to short the stock, you will get $2.50 for each share, or $250 for the contract placed into your account.
Because you can spend a little money to control a large number of shares, the potential profit percentages in options investing can be very high. So can the losses. Let’s see how that works out using our examples above.
Case 1: Microsoft is at $27.50 on April 19, 2006
Bought 100 shares of stock at $25
If you bought 100 shares of Microsoft at $25, you paid $2,500 for the stock. When you sell it at $27.50, you will get $2,750 or $250 in profit.
Initial Investment: $2,500
Ending Value: $2,750
Profit: $250
Return on Investment (ROI): 10% ($250 / $2,500)
Bought 1 call contract for $0.75
If you bought 1 call contract for $0.75, you paid $75 for the right but not the obligation to buy 100 shares of Microsoft at $25 per share on or before April 19, 2006. You would exercise the call and sell the stock, netting you $250.
Initial Investment: $75
Ending Value: $250
Profit: $175
ROI: 233% ($175 / $75)
Bought 1 put contract for $0.75
If you bought 1 put contract for $0.75, you paid $75 for the right, but not the obligation to sell 100 shares of Microsoft at $25 per share on or before April 19, 2006. You would let the option expire, since it would make no sense to buy the stock for $27.50 and then sell it for $25.
Initial Investment: $75
Ending Value: $0
Profit: $75 loss
ROI: -100% (-$75 / $75)
Case 2: Microsoft is at $22.50 on April 19, 2006
Bought 100 shares of Microsoft at $25.00
If you bought 100 shares of Microsoft at $25, you paid $2,500 for the stock. When you sell it at $22.50, you will get $2,250 or a $250 loss.
Initial Investment: $2,500
Ending Value: $2,250
Profit: $250 loss
Return on Investment (ROI): -10% (-$250 / $2,500)
Bought 1 call contract for $0.75
If you bought 1 call contract for $0.75, you paid $75 for the right, but not the obligation to buy 100 shares of Microsoft at $25 per share on or before April 19, 2006. Since you do not want to pay $25.00 for a stock worth $22.50, you would let the option expire.
Initial Investment: $75
Ending Value: $0
Profit: $75 loss
ROI: -100% (-$75 / $75)
Bought 1 put contract for $0.75
If you bought 1 put contract for $0.75, you paid $75 for the right but not the obligation to sell 100 shares of Microsoft at $25 per share on or before April 19, 2006. You would exercise the put and buy the stock, netting you $250.
Initial Investment: $75
Ending Value: $250
Profit: $175
ROI: 233% ($175 / $75)
As shown in the examples above, options can make a much higher percentage profit for you than investing in stocks; however, if you are incorrect in your estimate of the direction that the stock will move, you can also lose all of the money you invest.
Hedges Aren’t Just For the Yard
Options can be used to protect you from unexpected turns or to lock in profits.
Let’s take the Microsoft example above a little further. Say you purchased Microsoft for $20 a year ago, and it’s now at $25.00. You don’t want to sell the shares because you heard about some great new operating system called Vista, and think that it might help the stock. Then again, they were late with Windows XP, and if they’re late with Vista, it might hurt the stock. Because of the potential upside, you don’t want to sell the stock, but you’re worried about losing out on your profit in case the stock tanks.
The solution? Buy a put. You can use buying puts as insurance against stock declines. Just like you buy insurance on your home for a small fraction of the value of the home to ensure against catastrophe, you can use puts for the same reason. This is known as buying a “married put,” since you already own the stock against which you are buying the put.
You can buy a Microsoft 22.50 put for some time in the future past when Vista is supposed to be released to help protect your profits. Let’s say that you can buy a January, 2007 put for $0.75. If Microsoft drops below $22.50, you are protected, because you have bought the right to sell Microsoft at $22.50, locking in some of your profits. If Microsoft goes up, you will get the benefit of owning the stock and gain in the stock appreciation. If Microsoft is unchanged, then you still have your gain in the stock, and you’ve paid for the security of being able to rest easy at night. In that sense, the notion of insurance is very similarmost of the time you do not use the insurance. You pay a fractionally small price of the value of your asset (your home, your stock) for the ability to sleep at night knowing that if the worst happens, you are protected.
Another way to use options to help lock in profits is through selling calls against stock that you already own. When you sell a call, you are selling the right, but not the obligation to buy stock to another person. Let’s take our Microsoft example again. Say you purchased Microsoft for $20 a year ago, and it’s now at $25.00. You think that Microsoft has gone as far as it’s going to go because open source technologies will start to nip away at some of its profits in the future. You don’t want to sell the stock outright; you’d like to get a little more out of it before selling the stock.
You can sell a Microsoft 20 call for some time in the future. Let’s say that you can sell a Microsoft June 20 call for $6.00. This is called selling a covered call, since you already own the stock that you would have to deliver if the call that you sold is exercised. As long as Microsoft remains above $20 by the third Friday in June, the call you sold will be exercised, and you will sell your stock to meet your obligation to the person who bought the call from you. You will lock in a $6 profit for each share of Microsoft that you own.
There are two downsides to this strategy. The first is that Microsoft could keep going up, and you will not be able to participate in the upside. The second is that Microsoft could drop well below $20, and you would still own the stock. One mitigating factor is that since you had already received $6 for the call that you sold, you will have lowered your cost basis to $14 per share.
Using covered calls is an excellent way to generate additional income out of stocks. You can sell covered calls that are for strike prices above the current price to generate income on your stocks. You can sell covered calls that are for strike prices below the current price to provide limited downside protection in case the stock drops.
In conclusion, there are uses for options in your portfolio. If you wish to be speculative in your investments, you could set aside a small percentage of your investment capital to buy calls and puts. This strategy is definitely a high risk, high reward strategy, as you are looking for potentially high percentage returns, but you could also lose all of your investment much more quickly than if you invested in stocks or mutual funds exclusively. The other use is for insurance and to generate additional income. You can buy married puts or sell covered calls to protect yourself against downward turns in your stocks.
Resources
Options Industry Council Options Education Site: http://www.888options.com
(C) 2007 by the author