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A Guide to Trading Options

These lessons are provided by Mike Burton ( Tayonee in our Chat-Room )


Welcome, come in, relax and join our informal look at options trading. I would like to begin with a very basic overview of options and how traders can use them to increase profits while protecting their portfolios. Later in the series, we will discuss strategies and techniques professional traders use to beat the S&P on a consistent basis. If you don't have time to read the posts now, or would like to use them as reference material, you might consider copying and pasting the text to a file that you can save or simply print a hard copy. For all of you seasoned options traders, bear with me until I cover Options 101 and then I will get to the fun part; making money.

Part 1

A general definition of a stock option is a contract offering the right but not the obligation to buy or sell a stock at a specified price on or before a given date.

Let's look at it in a different light. What if you decide to buy a used car and grab the weekend newspaper to look at the classified ads; then you make a list of the cars offered for sale that are of particular interest and meet your price range. Now imagine looking at the first car and really thinking it's the one for you, but your nagging partner or mate advises you to look around before buying the first one you've looked at. Now who's to say the seller won't find someone else to unload the car on before you get back to him. So you offer him a $20 bill to hold the car for you for one week and he promises not to raise the price if you decide you can't live without the car. That is a 'call option' contract, and whether or not you buy the car, the seller gets to keep the $20 for promising to hold the car for one week and not raise the price no matter how much interest develops in it.

Make sense now? OK. There are two kinds of options - calls and puts. A Call option gives the holder the right but not the obligation to buy a stock while a Put option conveys the right to sell a stock. For example, if you buy a call option on ABC Company currently trading @ 67.50, the April 70 call costs 2.25, and gives you the right to buy ABC stock @ $70 before or on the expiration date in April - no matter how high the stock price rises (in this example, $70 is the strike price of the option). Likewise, the April 65 Put costs 1.75 and entitles you to sell ABC stock at $65 on or before the contract expires in April - no matter how low the stock price falls. The specific stock on which an option contract is based, in this case ABC, is called the underlying security.

Options are considered derivative securities because their value, in part, is derived from the underlying security. As derivatives, they are often traded on the market as separate entities with no intent on the buyer's part to exercise them for the purchase or sale of the underlying security. In other words, traders often purchase options to trade similar to the way they would buy and sell stocks for a profit. An option contract refers to a unit of 100 shares of the underlying security. Option quotes are for one share, so a quote of .75 equals $75 or (.75 times 100 shares).

 As a general rule, options expire on the third Friday of the designated month. Later we will discover that some index options expire on the preceding Thursday (e.g.: SPX (Standard & Poors 500) SOX, (Philadelphia Semi Conductor Index) ^DJT (Dow Jones Transports Index) to name a few.

 LEAPS: Or Long-term Equity Anticipation Securities are long-term stock options that provide the owner the right to purchase or sell shares of a stock at a specified price on or before a given date up to three years in the future. As with other options, LEAPS are available in two styles, calls and puts. We will discuss LEAPS in further detail in some of the articles that deal with different trading strategies.

Types of Options: There are three types of options: American, European and Capped. American options offer the holder the right to exercise the option on or before the expiration date otherwise it expires worthless, while the European style option can only be exercised during a specified period of time prior to its expiration. Capped options gives the holder the right to exercise the option only during a specified period unless the option reaches the cap value prior to expiration, in which case the option is automatically exercised. Currently, all exchange-traded options are American style.

Option Contract Expiration: In the case of exercising an option, the holder must notify his broker who in turn notifies the OCC. The OCC then assigns the exercise notice to one or more Clearing Members according to established procedures. Although the procedures may vary from one brokerage house to another, it is a good idea to discuss this matter with your individual broker. The OCC has a procedure called Exercise by Exception to expedite things, which sets in-the-money parameters to automatically exercise if the options meet the criteria. Well that's enough for one lesson, lets finish our coffee and I'll look forward to seeing you again in Part 2 when I will discuss how option contracts are priced.

Part 2

The Pricing of Options: Options values are based on several constantly changing variables. The key factors influencing the price of an option include: the price of the underlying stock, the amount of time remaining until expiration, and the volatility of the underlying stock. Options with strike prices below the current stock price are referred to as in-the-money (itm) options. An example of this is the May 75 calls on XYZ Company, if XYZ is trading at 80. In this case, the option is $5 in-the-money. Therefore if the May 75 option trades at $7, it has an intrinsic value of $5 and a premium of $2.

Conversely, call options with strike prices that are above the current price of the underlying stock are said to be out-of-the money (otm) options and options with strike prices equal to the stock price are at-the-money options. Therefore, as the strike price of the option moves further away from the price of the underlying option its value decreases.

Time Premium: This is an important factor of option price. The more time remaining before expiration, the more expensive the option premium will be. This is due to the greater possibility that the underlying stock will reach the strike price or move in a favorable direction. As the expiration date nears, the time premium will decrease particularly in the last weeks and days it trades. Volatility is the fluctuation of the underlying stock's price. Generally, greater volatility results in higher option prices, due to the larger price swings.

Part 3

Options are used by savvy traders for various strategies ranging from hedging their portfolios against market declines to leveraging speculations, purchasing stocks at lower prices and increasing returns. Let's look at some of the techniques traders use to beat the S&P year after year.

Leveraging: Options offer the buyer the opportunity to leverage his/her investment in the market. Rather than paying $7,000 for 100 shares of ABC Company, currently trading at $70, a savvy investor could buy the July 65 call options trading at $7.50. For every $750, you control 100 shares of ABC until the contract expires the third Friday in July. Or you can control 1,000 shares for nearly the same investment as buying 100 shares. Since the option is in-the-money, it will appreciate in value as the stock price increases. Early in the contract, the increase should be dollar for dollar with the stock increase, but don't forget the time premium which lowers the option price as it approaches the expiration date.

Let's say the stock price increases to $80 and the call option appreciates to $15.50, you can close out the position by selling the option for $1,550 for an $800 profit. This trade would yield a profit of 106%, while purchasing the stock for $7,000 would yield a profit of $1,000 or only 14.3% ($8,000 sell price for 100 shares minus $7,000 purchase price @ $70/share). The down side of this strategy is, if the underlying stock price falls below the strike price on the expiration date, the option will expire worthless and you will lose your initial investment.

Owning the stock means you cannot lose money unless you sell the stock below the purchase price. On the other hand, in the event the stock falls significantly you may have less invested by using options.

Buying Put Options to Protect Downside Risks: Considering the significant gains many people are currently enjoying in their portfolios, there is a great deal of temptation to sell and protect profits. The problem is, this action may cause you to miss out on future profits and besides, if you do sell some of the stocks in your portfolio, you will need to reinvest the money in similarly high priced stocks. The answer may be to purchase put options on your equities, which will appreciate in the event the price of the underlying stock falls. Let's say you bought stock ABC at $50 and it's now $80. If you sell the stock, you will miss any future appreciation on the stock as well as incur capital gains liabilities, but you don't want to see your profits slip away incase the markets correct. The answer, purchase a July 70 put options on ABC for protection.

Reducing Entry Price: Traders also use puts to enter a position at a lower price. Let's say you really like stock DEF, but it has run up so much lately that at $130 you feel it may be due for a pull back. Still if you wait for it to fall in today's market, who's to say it will not go to $140. Switch gears for a minute and consider selling May 120 puts on DEF instead of buying them. This contract says you will buy DEF for $120 if it closes below $120 on the third Friday of May. For selling the puts you receive $6/share or $600 (100 shares in the contract x 6 = $600). This means your net cost for the stock is $114, not $130 (120 strike minus 6 for selling put). And the great thing is if the stock doesn't drop below $120 on the expiration date, you still get to keep the $600. This strategy can yield a profit with no money invested.

Part 4

Many of today's new investors who were accustomed to annual profits exceeding 25%, believed those returns would continue as long as they were willing to send monthly checks to one of the thousands of mutual funds currently on the market. In reality less than one quarter of mutual funds beat the S&P 500 in a given year and given the current conditions, even less. Investors, desiring continued success, need to reevaluate their current strategy while factoring in the effect of lower corporate profits, which results in slower stock price appreciation. The smart money on Wall Street is employing various techniques, including stock options to improve the total return on their investments. But don't expect to see these professional investors speculating with option contracts the way some of the new comers trade them. Stock options have become a vehicle for speculation on their own as players trade the derivatives much in the same manner as regular equities.

Success trading options is even more elusive than trying to time the direction of the next market move or hoping to predict the next favorite stock to be romanced by the Wall Street boys or abandoned by them. On national average eight out of ten option contracts expire worthless. Unless you feel you can beat these odds, it may be time to go back to the basics and ask why options were introduced in the first place.

The original purpose of options was to act as insurance, hedging investors' gains against future market downturns. Once significant gains are made in a previously purchased stock the owner simply buys puts on the equity locking in profits, without the need to sell the stock. This practice allows the stockowner to hold the equity in anticipation of future gains, while avoiding selling the position, which would incur capital gains taxes and additional commissions to reenter the position.

By taking this technique a step further, the astute investor can generate remarkable profits on a regular basis. Working on the premise that 8 out of 10 option contracts expire worthless, we should consider being the option seller, rather than the buyer. This method is referred to as writing (selling) covered calls because the investor buys the stock and then sells a contract to offer the stock at a set price on a stated date. Some might argue that this minimizes the upside profit potential of owning the stock. However, giving up some of the future profits for 'guaranteed', immediate profits on a frequent, planned schedule far outweighs the alternative. In other words, the investor has taken control of regulating profits by depending on the sale of option contracts, rather than depending on stock appreciation, which is dependent on such variables as future earnings, p/e valuations, market volatility, sales volume, etc.

While the basic plan sounds simple enough, there are many complexities that must be considered in order to maximize success while eliminating some of the obvious pitfalls. The first consideration of course is picking the right stocks for the program. Additionally, the portfolio must be diversified to avoid market sectors that are currently rotating out of favor with institutional traders, in favor of the 'hot' sectors. Other considerations for stock choice include the liquidity of the stock as measured by daily volume, the stock price volatility and the price of option contracts available for the stocks. The purpose of this essay is not to discuss stock picking, but to outline the strategy of the overall portfolio. Which leads us to the chore of picking the correct option to write, after choosing the right stocks. Again this task is best left to the professionals, who must constantly monitor the stocks as well as the market trends, once the stocks and option contracts have been chosen.

The next component of the program is to take advantage of leveraging your money to enhance the average return on the portfolio investment. By employing margin 'borrowing' from the brokerage house that handles the trading account, the portfolio actually has the opportunity of doubling monthly profit returns. The brokerage house will loan an equal amount of money, for use to buy more equities, based on the value of the stocks in the account as collateral. The general rule of thumb for charges on this money is a small fraction of a percent above the prime rate. One thing that must be considered at this point is the right of the brokerage company to 'call' the margin account (ask you to liquidate the stocks and pay back the loan) if the value of the account falls over 30 percent. This is easily avoided by placing stops on the stock at approximately 10% below the purchase price and by monitoring the stocks daily. Also the account is increased by the sale of the option contracts, by ten percent, so the stock value would actually have to fall below 40% of the purchase price. No astute portfolio manager would allow this to happen without taking action long before this much depreciation could occur.

At this point it might be prudent to regress to the fundamental goal of the program, which is to make regular monthly profits from the sale of stock option contracts and not the appreciation of the stock value. Keeping this goal in sight, the options are selected with the intent of having the stock price meet the option strike price and having the stock bought away from the account. Later in the examples it will become clear how this action will actually increase profits in the portfolio, by adding to monthly income.

Further gains in the managed account will be realized by writing (selling) put contracts on the equity. This is an option contract that states the writer will purchase an equity at a given price on a set date in the event the stock price falls below the strike price of the contract on the specified date. The account manager has no intention of holding the equity should it fall to this price as previously stated by employing stop sell orders on the position. The alternative is to repurchase the stock at a lower price if the equity falls to that point, or simply buy back the put contract. If the former action is chosen, the trader will write new call contracts on the position, as well as more put options, and the process will begin anew for the next month.

Part 5

"Ok Tayonee, I'm convinced, options offer great profit potential and I've chosen a stock, so which option do I buy or sell?" That has got to be the most frequently asked question. My standard answer is, "Well it depends on your objective." Let's look at some of your choices.

I will use XYZ as an example. ZYZ closed at $75.00 +2.35 close on 4/20.
Lets take a look at some of the available call options on this stock.     

Strike Month Closing Price Increase Volume
70 May 8.00 +1.75  248
75 May 4.50 + 0 .75 850
80 May 2.40 + 0 .75 1,713
70 July 11.25 + 1.35 42
75 July 8.35 + 0 .75 216
80 July 6.00 + 0.50 79

If you are writing (selling) Covered Calls, the May 70 call only yields
$3.00 or 4% profit (8.00 minus 5.00 in the money) with no upside
potential. The May 75 offers 4.50 yield or 6% but still no upside potential. And finally the May 80 yields $2.40 or 3.2% but add the upside profit potential of being called out of the stock at expiration for $80 and the profit increases to $7.50 or 9.9% in only one month. Of course buying the stock on 50% margin doubles the yield, but that is another lesson. Bottom line, if you feel the stock will go up then consider buying the stock and selling the May 80 out of the money call options. If you feel it will go down consider selling the May 70's naked (or without purchasing the stock).

Considering the same scenario, but with the July calls will offer higher yields, but over a longer time frame. "But Tayonee, what if I think the stock is going up and I just want to make profits on the stock rise without spending $7,500 for 100 shares?" Response: Look at the same options, but recalculate your returns, considering the following: Option prices move on four major factors: price of the underlying stock, the time premium until expiration, the volatility of the stock price, supply and demand. I would suggest buying the May 70 calls because they are safer, since they are deeper in the money, and they demand less premium. Let's look at the premium. Paying $8.00 for the May 70 is only $3.00 premium ($8.00 minus 5.00 in the money) while the May 75 premium is $4.50 since the strike price is at the money. Lastly, the May 80 premium is $7.40 or 2.40 plus $5.00 (the price the strike is out of the money). Adding the safety of buying options in the money will significantly improve your year-end performance by lowering the downside losses in case you predict the stock movement incorrectly.

Part 6

Finding the Top: Picking the top of stock prices has to be the most elusive part of the trading game. Try finding one trader who hasn't left some profits on the table and hasn't asked himself why he sold too soon. Or worse yet, how about the greed in all of us that prompts us to hold on just one day too long as we watch our profits slip away while others scramble to the sale side and take their profits. These lessons are even more important when we employ options as part of our trading strategy. After all if you miss the top of a stock, you can always hold it long enough to watch the stock inch its way back, but options have a contractual expiration date and you don't always have the luxury of waiting. First, consider your reasons for buying options rather than buying the stock. In most cases, you are looking for a fast return on your play, with a minimum investment. Now add in the fact that the national average for option success is 2 out of 10 and you should at least be shooting for a double.

The strategy I like to use is to buy enough options, say a minimum of 10 contracts, so that I have the chance to sell half of my positions as soon as it doubles. That way I can't loose any of my original principal and the rest of the trade is virtually free. Let's look at an example, say you bought ABC May 70 calls on April 7 for $5 with ABC closing at 70.50 on 4/24 ABC closes at 74.50 (+4.00) and the calls are trading at 7.75. As soon as the option hits $10, I would suggest selling 1/2 your positions and speculating on the other half.

Part 7


A friend sent me some technical charts on the DOW that shows a short-term top forming around the beginning of January, which was followed by a correction. I agree with this analysis. After all the last two times I spoke with you I said the DOW would fall below 10k by the end of February, and many more people believe me now than they did a few weeks ago. So what do you do w/ all of this valuable information on the markets future direction? Most people buy stocks, hold them, and hope they go up. I know many of you own shares of blue chip companies that you have held for many years w/ no intention of selling. The capital gains alone would prohibit it. I also listen in chat rooms during down market corrections when everyone complains about their portfolios being down 30 to 40% w/ the correction and all they see is red. Well that leads us to our next option lesson - LEAPS.

Simply put, LEAPS are long-term options that expire the third Friday of Jan 2003, Jan 2004 or Jan 2005. They come in two flavors, puts and calls and trade like most other options. OK so how do they help you in a down market correction? Lets say you own 500 shares of DEF and you don't want to sell the stock but you also don't want to see your portfolio go down if the markets fall significantly. The answer is to buy 'insurance' on your portfolio. After all you wouldn't think of owning a house without insurance, and you should not have a long-term portfolio without insurance either.

The more volatile the markets, the more you need a way to protect your wealth. OK back to the 500 shares of DEF you want to protect. DEF closed at $105; you can buy a Jan 2003 (leap) Put on DEF with a strike of 100 for 8.75 ($8.75 x 100 shares = $875.) The option doesn't expire until Jan. 17, 2003 and protects you if DEF's share price falls. As the price of DEF stock falls, the price of the Puts goes up. So lets say DEF falls $20/share in a 20% market correction. The price of the puts will go up nearly $20. With 500 shares your stock will show a portfolio loss of $10,000 but the Put option will go up nearly $10,000 (on 5 contracts- one for each 100 shares of stock) and your overall portfolio will remain at the same value.

Once you think the correction is over and the markets begin a climb back up, you simply sell the puts and take your profit. Eventually DEF will return to its price of 104 or so and you will be ahead the profits from the sale of your 'insurance policy' the Puts. Think about that, you can go to bed not worrying about the markets falling. If the markets go up your stock will appreciate and you will make money, if the markets go down, you will make money on the Puts you own.

Now lets get really creative! When you think the markets have fallen as much as they are going to and you decide to sell the LEAP Puts, why not take the profits and buy LEAP Calls on DEF. That way you will make even more money when the stock rises again. No one can predict the markets w/ regular consistency, but I would be willing to bet nearly everything I own, that sometime in the next 10 months the markets fall back on a correction and when they do, you will be glad you bought LEAP Puts for insurance and I am certain that you will profit from them.

Hope everyone understands that, because its time for part 2 of the lesson on LEAPS. Last we talked about selling covered calls on your stocks to make extra profits on a regular basis. Well did you know you could sell covered calls on LEAP calls the same way? Actually, its called a calendar spread. The way it works is; instead of buying a stock and selling covered calls on it, you buy a LEAP Call (at the money strike) and then sell a covered call at a higher strike price on the LEAP. If the stock price closes above the strike price of the covered call you sold, you sell the LEAP Call and buy back the covered call you sold.

If the stock price closes below the strike price you sold, you keep the money from selling the covered call anyway and sell the next month covered call on your LEAP. Lets look at the following example: XYX closed today at 119.65 if you wanted to buy the stock and sell a covered call on it, it would cost $11,965 and you could sell the April 130 covered call for $3.75. That means if XYX closes higher than 130 on the third Friday of April, you would sell the stock to cover the call and you would make 130 minus 119.65 = $10.35 plus the $3.75 for selling the call for a total profit of $14.10 on an investment of $119.65/share ($141 profit for $11,965 investment). On the other hand you could buy the Jan 2003 strike 120 LEAP Call for $22.35 and make nearly the same profit ($13.75/per share) or $137.50 profit on $2,235 investment.

Please check this site for more lessons and options trading strategies in the future.

These lessons are provided by Mike Burton ( Tayonee in our Chat-Room )

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