Investing - Part III

Options

Note: Options carry a special level of risk and are not intended or appropriate for every investor. Before considering any option trading, I strongly recommend visiting the Chicago Board of Options website http://www.cboe.com to learn more about the mechanics and then talk it over with your broker. Chances are you firm has additional forms that you will need to fill out along with higher capital and experience requirements. Trading of options should only be undertaken after a discussion with your broker about your account and your situation.

Welcome to Investing - Part III or "So what exactly are my options?"

There are two things that will kill a successful trader quicker than anything else: a lack of discipline and pure unadulterated greed. Between them, those two weaknesses will leave traders holding loser because they wouldn't trade out of them when they were winners.

Wouldn't it be nice to find a tool that could help to avoid those problems? How about one that could be used to magnify a gain (or loss) on a stock? Maybe you'd like to charge rent for your stock. Want to make money being long in a stock that's in a sideways trend? Need to lock in a gain, but don't want to lose the stock dividend?

Options, when used properly, can fill all these needs. But before we can go into much detail as to how options can help, let's look at what they are.

Options are an investment known as a derivative. Simply put, its value is derived from the value of the underlying stock. Generally, but not always, an option contract represents 100 shares of the underlying stock. Prices are quoted on a per share basis, which means you need to multiply the price by 100 to get the true cost of the contract (not including commissions and/or fees).

There are two kinds of options: Puts and Calls. How they affect you depends on the type and whether your position is short or long.

A Put obligates the seller to buy 100 shares of a specified stock at a specific price on or before a certain date in the future. If you buy a put (you're long), you have the right, but not the obligation, to sell 100 shares of the stock at the agreed upon price anytime up until the expiration date of the option. If you sell a put (you're short), you have the obligation to buy 100 shares of the specific stock at a specific price until the expiration date of the option.

Calls obligate the seller to sell 100 shares of a specific stock at a specific stock on or before a specific date in the future. If you buy a call (you're long), you have the right, but not the obligation, to buy 100 shares of the specified stock at the agreed upon price anytime up until expiration date of the option. If you sell a call (you're short), you have the obligation to sell 100 shares of the specific stock at a specific price until the expiration date of the option.

The agreed upon price is called the strike price. The expiration date will always be the Friday preceding the third Saturday of the month.

So how can options help you to avoid problems with discipline and greed? Let's look at an example. Let's say you own 100 shares of XYZ. You bought them intending to trade out of them when the rose 10 points from 15 to 25. Today they hit 25. Now you could sell the stock outright, take your 10 points, and spend the rest of your life boring friends at cocktail parties with the "killing" you made on XYZ. Or you could reevaluate your position.

If you reevaluate the position and decide that XYZ will probably keep going up, you might want to look at buying a put a month out at 25. Let's say it costs a $1 to buy that put. What have you done?

If the stock continues to rise, you spent the $1 on an insurance policy that was never cashed. But say the stock tanks to 13 during the month. At that point you exercise your option, sell at 25 and take a 9-point profit, as opposed to a 2 point loss had you not bought the option. That's an 11-point swing in profit because of your $1 insurance policy. Not a bad deal, huh?

You can also do this at the time of purchase to help minimize your downside risk on a trade. Long puts are a great way to protect long equity positions from significant price drops. I think of them as term life insurance for investments.

Now someone is going to say "But you can do the same thing with a stop order." That's only partially true. A stop order entails the risk that you will trade below the stop price. A stop limit may not trade at all if the stock blows through the limit, as it can when it gaps down after a halt. Put options have the assurance of being able to exercise at the strike price, no matter the price of the stock. I watched one day a few years ago as HIFN lost over half its value in about thirty minutes (a little more than a 35 point drop). People with stops were getting filled at half their stop price; people with stop limits sat there trying to figure out why their order didn't fill. I talked to one guy who had 60 puts for two months out. He was happier than could be. He could wait for two months before selling to see if the stock might come back, and if it didn't (it didn't), he still knew what he would get out of it. Where other people had lost 35 points, this guy lost 15 and couldn't lose any more on that position.

That's what's known as hedging a position. You've bought insurance against it dropping in price. So if options are such great hedging tools, why is everyone so afraid of them? Why are there special disclosures for these types of derivative investments?

Options are leverage. With each contract representing 100 shares of the underlying stock, you can end up with a huge exposure on a stock, without putting up too much money.

Used right, this can sometimes be useful. Let's say you think that GE is about to make a breakout, going from so 35 to around 50. You'd like to buy 100 shares of the stock, but that would require $3500 and you've only got $2000 available. You could buy on margin, but then you risk margin calls and potentially losing more than your $2000 investment. So how can you benefit from the move you see GE making without exposing yourself to too much risk?

This is where options come in. If you were to look at a GE 20 call for two months out, it would probably cost you around $17.50-$18.50. That means that you be putting up say $1800 to "rent" 100 shares of GE stock for 2 months.

Option prices are composed of two components: the intrinsic value and the time value. The intrinsic value is the value per share if the option were to be exercised today. In our GE example, the intrinsic value is $15 ($35 stock price less $20 strike price). The remaining amount is called the time value. In our GE example, the time value is $3 (the $18 option price less the $15 intrinsic value).

Intrinsic value will change dollar for dollar with stock price changes, once the option is profitable (in other words, it has to have positive intrinsic value, or be "in the money"). Time value, on the other hand, is almost constantly declining, particularly in the last month of the option's life. Eventually at expiration, the time value will be 0.

So what happens if in two months, we were right and GE has gone to $50? We cash out the option, selling it for the intrinsic value of $30. Our net profit is $12 or 67% in two months (that's as compared to 42.8% if we had bought the stock outright). Now in this case we could have made more by borrowing on margin (75% return for that), but then we had the risk of losing our investment and being in the hole another $1500. With buying the call, our max loss was $1800, our original investment.

Many times, you'll find that the potential percentage profit is greater for using call options than for using margin. Also, a $3 time value is somewhat high for a non-volatile stock like GE, had the time value been $1 - which wouldn't be any more out of line than the $3 - then our profit would have been at 87.5%.

Now let's say that we have $3500. Do we buy 100 shares of stock or two of the 20 strike price options for two months out? Assuming the stock runs to $50, with the 100 shares we would make $1500. With 2 options bought at $17.50 each we would make $2500.

The point of this is that options can help to leverage your return. But it's not without risk.

Say in two months GE doesn't run. In fact it closes at $34.75 on expiration Friday. Owning the stock, you've lost $25 and you still have your position. Own the options, you've lost everything invested in them.

Stocks require you to be right once - you only have to pick the direction.

Options require you to be right twice - you have to pick the direction and the time frame. Miss on either one and it's all over.

So now we've seen how options can help you to hedge against a loss and how they can magnify a gain. I mentioned renting stock a few paragraphs back. What's that all about you ask?

When a stock gets stuck in a sideways market, oftentimes people get discouraged, as they see their only possible avenues of return as being either dividends or selling the stock. They don't know the beautiful secret you're about to learn, that of the covered call.

Now most of the hardcore option traders reading this are groaning. Covered calls are boring. There's none of the fast paced excitement of trading. But for someone looking to enhance a return on a stock without taking too much risk, covered calls may be just the way to go.

The idea behind a covered call is that you own 100 shares of the stock, so you sell one call option against your position. True, you have given someone else the right to buy your stock, but they pay you for that right (that's the rent part).

As long as the stock closes at or below the strike price, you keep the stock and their money. If it closes above the strike price, they take your stock, but they pay you the strike price for it. In a sideways market - the best for covered call writing - you can sometimes get away with writing the same calls against the same stock for several months in a row. I knew of one guy who wrote the same strike price option for nine straight months without every getting it called away. He sold each contract for roughly $1, nine months in a row. The stock itself was only trading in the low twenties, so when it was finally called away, he made over $9 a share in "rental profits" or nearly half the price of the stock!

Covered calls do limit your upside potential temporarily. Once the stock goes above the strike price plus the premium you collected when selling the option, you basically sit out the rest of any upside move. Some people can't stand that. They let greed get in the way and they try to buy back the call. They forget that when they sold the call, they said at that point that they would be happy with the profit that that strike price allowed. Never once did I see a client make more money because they bought a call back to uncover a position. Not once. Stupid greed (to be distinguished from the basic greed that is the whole reason behind the market to begin with) and a lack of discipline cost investors more money than anything else in the market.

And now to finish off this conversation, let's talk about Ted Turner and the UN. Seriously. Remember his $1 billion gift? Ever wonder how he was able to make it?

He paid for it with profits from the sale of some of his Time Warner stock. But how could he be sure that the amount of the gift would stay consistent during the negotiation process that preceded the announcement? After all, not even Ted Turner can come up with a billion in cash to give away on a few days notice. So how did he pull it off without committing more capital than necessary or without the value of his contribution losing value?

He used an option combination known as a collar. It's actually a very simple technique. First he would sell calls against the position, bringing in money, but limiting the upside. He then turned out and bought puts, spending money on insurance against a drop on the stock price.

So what did he achieve? If the stock price went up, he got his stock called and the cash was there to give to the UN. If the stock went down, he would exercise his puts and would still end up with the money to give to the UN. And he did it by "renting" the stock to pay for the insurance - no money out of pocket.

But why not just sell the stock? Suppose the deal fell through. With the options, he could unwind the option positions and would be able to maintain his position with very little cost out of pocket (and if the stock had dropped, he may have even been able to profit in that situation). Had he sold the stock, he would have to try to buy it back, and that many shares transacting on one side of the market will certainly create unwanted movement making the sale less valuable and the repurchase more expensive.

Options can be really fun and extremely useful tools in investing. They can also be exceedingly dangerous to someone who doesn't know how to properly understand them.

There are many options seminars available out there to try to make you more knowledgeable. Unless it is offered by the CBOE (and they do travel out sometimes to offer them), don't waste your money. They funniest phone calls we used to get were the little old ladies who wanted to do a credit butterfly spread with a bull moose straddle to hedge it. They would insist that they wanted one of each of the applicable contracts.

At that point we'd start asking for specifics, "What do you want to buy?"; "What do you want to sell?" These questions would invariably be followed by agitation on the part of the little old lady who would then tell us that she was in the bathroom at her option seminar and that the instructor wasn't available, but he had told her how this was the perfect strategy for everyone and we just needed to get it done.

We, of course, could not as she hadn't told us what she really wanted to do. She was throwing around fancy sounding names, not realizing that they only made her sound less knowledgeable.

Read the CBOE site. Learn how options work and what some of the different strategies are. Talk to your broker and make sure that you are in complete understanding. Then and only then should you apply to trade options on your account.

And just in case any one was wondering a credit butterfly spread with a small number of contracts is like throwing your money away. It takes quite a few contracts to make that a profitable strategy. And the bull moose straddle doesn't exist, at least not in the real marketplace. It sounds great in a seminar, but your broker will want to laugh at you if you use it.

Learn before you try to earn with options. I can't say it enough.

Resource:
CBOE.com

If there is enough interest, I might consider doing an advanced options post, looking at the most successful strategies. If you're interested, drop a note in the comments.

To get to the other sections:

Part I - Fundamental Analysis

Part II - Technical Analysis

Part IV - The Economy and The Market

Part V - Market Mechanics

Part VI - Mutual Funds

Part VII - Asset Allocation

Part VIII - Bonds