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OPTIONS BASICS, AND MORE
A PRIMER ON CALLS AND PUTS
One can trade options on
individual stocks, stock indexes, or other investment assets such as interest
rates, commodities, and financial futures contracts. All options, regardless of
the underlying security, share similar characteristics.
Let’s look at options on
stocks and stock indexes, referred to as equity options and index options.
There are two types of stock
options, calls and puts. A call gives you the right to buy 100 shares of the
underlying stocks at a specific price (strike or exercise price) for a
pre-determined time.
A put option accords you the
right to sell 100 shares of the underlying stock at the put’s exercise or strike
price for a pre-determined period.
You would buy a call if you
expected the stock to rise. You would buy a put if you thought the stock was
about to decline.
In both cases, you would
expect the stock to move over the next six months. The date the option expires
is referred to as the expiration date.
Equity options, and most
index options, expire on the Saturday following the third Friday of the
expiration month. The Saturday expiration allows the options clearing
corporation to settle all expiring-option contracts prior to the next trading
day.
You can also sell options.
This is referred to as writing an option. The compensation an investor receives
for writing an option – or the price an investor must pay to buy an option - is
referred to as the premium.
Then there are transaction
costs. Not all brokers can trade options. They must be licensed. Commissions
are paid when options are bought, sold, exercised or assigned.
To clarify, if you buy the
option, you have the right to exercise. If you sell the option, you have taken
on an obligation and can be assigned an exercise notice.
Option commissions seem
high, especially when compared to the cost of buying stock. The commission for
an option can be as high as 6% of the purchase price. But, to be fair, you
cannot compare the cost of purchasing an option contract in the same light as
buying a similar quantity of the underlying stock.
Discount brokerage firms
charge less than full-service brokers and are the way to go is looking in the
mirror is all you need to enter option orders with confidence.
Options trade on an
exchange, just like shares of stock. The largest options exchange is the
Chicago Board Options Exchange (CBOE). Others include the American Stock
Exchange, which also lists a number of interesting derivative securities, and
the Pacific Stock Exchange, best known for its handling of the active Microsoft
Corp. options.
THE
COVERED CALL
Ø
So safe, recommended for RRSP
accounts.
Ø
Lower your cost on stocks you
already own.
Ø
Buy stock at a “discount” to their
current price.
Ø
Make as much as 10-20% per month.
Ø
Cushion yourself in case the market
crashes.
Ø
Make money when stocks go up,
sideways or slightly down.
Karen buys 100 shares of IBM
at $90 per share (total cost of $9,000).
Karen’s neighbour, Gary,
pays a visit. After a short conversation about IBM, Gary offers to pay Karen
$10 per share ($1,000) to sign a contract (contract will expire in one month)
stating that she is willing to sell her 100 shares of IBM for $95 per share
($9,500). According to the contract, Gary has the right to buy the stock from
Karen at $95 per share ($9,500). Gary is not obligated to buy the stock at $95
if he doesn’t want to.
The one-month contract is
about to expire and IBM’s price is above $95. Gary comes knocking on Karen’s
door, takes Karen’s certificate of 100 IBM shares and pays her $95 per share
($9,500). Karen made $15 on an $80 investment (18.7%).
The one-month contract is
about to expire and IBM’s price is below $95. Gary lets his contract expire
worthless. Why should he pay Karen $95 for IBM when he can buy it cheaper in
the market? Karen gets to keep her 100 shares of IBM.
In both scenarios, Karen
lowered her cost basis on her shares of IBM as soon as Gary bought the contract
from her. In essence, the stock could have stayed the same price or even gone
down slightly, and Karen would still have made money.
Karen wrote a “covered
call”. It is considered “covered” because she owned the shares of the stock
prior to signing the contract with Gary. Therefore, if Gary came knocking on
her door requesting “his” shares of IBM at $95, she could sell it to him without
having to actually go into the market to purchase the shares herself (possibly
at MUCH higher prices). Since she owns the shares, she is considered to be
“covered”.
A “covered call” investor
can make money in up, neutral and even slightly down markets. It is important
to remember that once a contract expires and the stock doesn’t get taken
(“called”) away from you, you can continue to lower your cost basis on the stock
by selling yet another call against your stock position.
By selling covered calls
against your entire portfolio, you might be selling away your winners (because
they can be called away), and you might be left with your laggards. This is
because premium income derived from selling covered calls is the highest when
stock market volatility – a key variable in determining the option premium – is
at its highest.
The downside I am talking
about is having to sell the stock to the investor who bought the call if the
stock rises above the strike price, thereby leaving some money on the table.
However, you get to keep the premium no matter what happens to the underlying
stock price.
It is a wise strategy to
sell calls on steady stocks because the risk of the price rising above the
strike level is lower.
A covered call strategy is
great for companies out of favour, as you can write calls at or slightly out of
the money. Therefore, you need not put your ‘winners’ at risk with a covered
strategy. As well, you would be writing the calls against the ‘winners’ that
are out of the money, so that your risk of being called is lowered – though your
premium is also lower.
An investor who writes
calls against a portfolio does enhance the return on the portfolio, but if their
short call is called away the investor just buys the stock again and writes
another call. The investor will know within 24 hours that the exercise has been
made and he can replace his position.
Any investor that doesn’t
use covered calls is leaving money on the table because the premium to be earned
enhances the value of the portfolio and does not restrict the investor from
benefiting from higher prices of the individual stocks or commodities.
While it is true covered
call writing calls away your winners, such need not be the case. An investor
can perform a repair strategy whereby they would roll out in time and up in
strike price, a process called rolling out and up.
Covered call writing
attempts to deliver a consistent return by trading off very good years of stock
market gains for protection in some bad years. Accordingly, covered call
writing is viewed as an appropriate vehicle for wealthy individuals looking for
more stable investment returns.
But stability has its
price. And, in general, an investor is better off with owning stocks in times
of market gains but better off with covered calls at a time of market losses.
THE
MULTI-MILLION DOLLAR WINNERS' SECRET
Buy cheap calls that are out-of-the-money and lackluster in
performance – the ones no one wants. Often, when a market like soybeans is in
the doldrums, smart money will buy cheap call options. When the market rallies,
the buyers of the cheap options make fortunes.
You can purchase listed call options on just about every
futures contract today. With more than 30 days left to expiration, there are
call options selling on the cheap that could magnify considerably in the event
of a bull run in the underlying commodity. Floor traders routinely write these
options by the hundreds – their reason being that they will expire worthless –
but not all the time. Once in awhile, these out-of-the-money calls can yield
enormous profits for their astute buyers.
OPTIONS ON
FUTURES AS PRICE INSURANCE
Options on futures provide an opportunity to hedge
positions. To make a fat story thin, you buy calls to protect short futures
positions and buy puts to protect long positions.
As an illustration, if you purchased March Soybeans at
$4.50 a bushel and they are now at $5.00, you could buy a March 500 put to lock
in your 50 cent profit. If prices were to rise above $5.00, you would simply
abandon the put. If, on the other hand, prices declined below that level, you
could exercise the put and realize a selling price of $5.00.
Futures traders can pick up writing income by selling
options. The buyer pays a non-refundable premium to the seller, or writer. Why
would you want to do this? Let’s have a look. If you are long Soybeans at
$5.50 and you write a 600 call for a premium of 10 cents, that money is yours to
keep. You are, however, obliged to provide the buyer the right to “call away”
the futures at the $6.00 “strike price”. The good news is, you realize a gain
of 50 cents ($6.00 minus $5.50), and you get to keep the 10 cents in writing
income. So, hedge away. It’s just like an insurance policy.
WHAT TO DO IF YOU OWN THE PHYSICAL
If you own a commodity and need to sell it to pay off operating
expenses, cover the decision with call options. Option loss will be
less than a drop in the cash price, and there is upside protection in a
rising market. If you want to hold the product after a run up in
prices, you can lock in your position by buying a put. In addition to
the commodity trading rules and stock market successful trading strategies
revealed above, the trading secrets of the pros are waiting for you at
www.tradingsmarts.com/content.htm. |
BIG
DOGS EXPOSED 
