Options:
A general discussion about options
For some reason, there has always been a mystique about options. I suppose it's because options trading represents a zero-sum game where there is one winner and one loser and no other value is created except for the employment of intermediaries.
Professionals who do nothing other than trade puts and calls for their living now dominate the securities options market. The profits they earn (and you lose) also represents much of the bottom line income of the firms that employ them. Always remember that fact that when dealing in options.
Yes, in trading options, you are competing with Wall Street's most skilled people whose future depends on their ability to win and yours to lose.
For background, you should know I happen to like options trading. In 1984, shortly after joining a small 50-person broker-dealer firm that was a member of the Toronto Exchange, as Executive Vice President, I was seeking to recruit staff, I interviewed a fellow by the name of Richard Croft who showed me quite an impressive understanding of option strategies. He wanted to get started in the securities industry but those who were hiring didn't have a clue about options and Richard was pretty deep into it.
But I understood options and hired Richard based on the potential I saw. As he didn't have any clients and needed to promote himself, I then introduced him to the Globe & Mail newspaper financial editor who surprisingly gave him a major weekly column on the front page of the business section.
With his inimitable style and true expertise, Richard has gone on to become quite a media personality in Canada and one of the country's top options traders.
A year earlier, in 1983, as a money manager working for the Street's 800-pound gorilla, I had become an options expert in my own right, being published in national journals and all. One day, during the vacation absence of our departmental President, one of the other money managers (George is his real name) came to me inquiring about options. After a brief educational session, he seemed excited and wanted to try using them on his own accounts.
George was an elderly and cautious man who was the heir of a world famous manufacturing family. He showed me his family's extensive investment portfolio and I immediately saw a ton of a well known goldminer stock, Placer Dome (NYSE: PDG).
Now the brother of our firm's chairman and CEO was a director of Placer Dome at the time (soon to become its chairman) and I just happened to be personally managing that family's portfolio as well, so I knew I'd be on shaky ground when I advised George to start trading in PDG options.
In that case, I recommended a simple covered call writing strategy but remember, I was working for the biggest investment firm in the country, who were very conservative people who did not understand exchange-traded options, which at the time was a fairly new concept.
But, I also knew and understood the options and gold markets fairly well and coincidentally I happened to know Placer Dome, the corporation. Elsewhere on these pages, you will see that I've been a trader, analyst, retail and institutional salesman, and underwriter of gold stocks.
As for Placer Dome, I had taken the top three executives around to private breakfast and lunch meetings in places like Dallas and San Antonio TX to meet face to face with gold fund managers. I knew the company inside and out.
The prices of gold stocks and gold bullion metal are closely linked. If there is a trend reversal juncture, stock prices probably lead the bullion but the key point however is that if, as and when gold bullion prices are trending south, the stock prices of the major producers are doing the same.
Gold had bottomed in mid-1982 at just under $300 and in the following year had spiked to the 400 to 500-range, whereupon I had correctly forecast that it would decline again for at least a year. So, in the context of a bear trend, I believed the major gold stocks presented a great opportunity to write (i.e., sell) covered calls against a long stock position.
This situation is especially appropriate in cases where, like George, you don't want to sell, or your family does not want you to sell, the stock.
When you're looking strictly for income, writing covered calls is a proven investment strategy. I can't say the same for writing them naked or in buying them, unless of course you have done your homework and such trading is part of your speculative investor strategy.
Options are a zero-sum game, so in simple terms the seller of a call option is looking to earn the option premium, hoping it expires worthless. The buyer, who takes the other side of the contract, is speculating on a rally in gold prices that would take the price of gold stocks higher as well, whereupon they either sell the call option or exercise it at expiration. Somebody wins and somebody loses.
If you sell the call when you also hold the underlying stock, you are "covered". If you have to borrow the stock to cover you, you are "naked".
In dealing in gold commodities and gold stocks, there is always the buzz of a potential rally in prices. Because of this interest, call options on gold stocks usually trade at excessive premiums. It can be a call writer's sweet dream but also could be a nightmare.
So following my advice, George wrote something like 2000 calls, representing 200,000 shares, about $4 million of his family portfolio. He took into income the premium of about $10,000 and was extremely happy to have received this "found" money.
On Monday, our boss returned from vacation and, after reading the trading blotter and spotting the big options trade, literally exploded. I heard it of course because I occupied the adjacent private office. I didn't think much of the noise until he burst through my door waiving his paperwork. "What have you done! George tells me you put him up to this. George doesn't have a clue about option trading! Please explain."
After gathering myself, I did explain. I guess I was effective explaining options to a boss who didn't understand them because I wasn't fired, as I had feared. I did agree to watch George's position carefully and subsequently this episode did turn out successfully, as I had expected. The buyers of those calls were the losers and we were the winners.
Were we speculating, or investing? I definitely think the latter.
No part of the securities markets has changed more than options since exchange trading was organized in 1974. In the beginning, the number of options was limited, the volume small and price changes were closely related to those of the related stocks. But no more.
Today, there are options on everything from stocks to indexes, commodities and futures. Annual volume is into many billions of contracts representing probably trillions of shares of stock in the aggregate.
It is a mature market today but options prices occasionally move inexplicably with little relation to the price movement in the underlying securities. So you have to be careful.
Still, I believe that everyone who owns securities should use options as part of investment strategy. With careful management, options can boost income or bring short-term gains. Buying and selling techniques can also be structured for tax benefits.
Nature of the Options Market
Some people say options are a cross between trading in stocks and trading in limited-life warrants or commodities because they permit holders to control, for a specified period of time, a relatively large asset with a relatively small amount of capital.
As a time-based investment instrument, options on stock are rights to buy or sell a specified number of shares (i.e., 100 per contract) of a specified stock at a specified price (the striking price) before a specified date (the expiration date).
But, by definition, options are diminishing assets and they pay no dividends. And, the closer the expiration date, the less time there is for their value to rise or fall, which limits the investment or speculation interest in them.
While it's not that simple, I view buying options as speculative investing; and selling options as conservative investing. I'm not in the club that likes to call an options trader a gambler because its simply not true. If you believe that then you must also believe that soldiers and hunters have no right to guns.
The most popular and widely used option is a call, which is the right to buy the underlying stock. A put is opposite to the call as it is the right to sell the stock.
For sophisticated traders, there are seemingly complex combinations such as spreads, strips, straps and straddles. All this you can learn with several hours study.
Rather than try to educate you directly, I'll point you to the best source of information, which is the Options Institute Online Learning Centre of the Chicago Board Options Exchange:
Another excellent source of options education plus tools is at Yahoo Finance.
The cost of an option is called the premium. It varies with the duration of the contract, the type of stock, corporate prospects, and the general activity of the stock market. By looking at the options data for a stock, you can see that premiums run as high say as 15% of the value of the underlying stock.
For example, for a volatile stock selling at 50 (i.e., $5,000 for 100 shares), the premium for a call to be exercised 9 months from now might be 7.50 ($750). Shorter-term calls carry smaller premiums, say from 2% for those expiring in a month to 7% for those callable in about six months.
For the securities trader, the twin lures of options are low cost and high leverage.
For a case study, let's turn the clock back to November 5, 2003, where for about $270, the trader could control 100 shares of Dow 30 ABC (the name's not important) selling at 74.53 ($7,453) for about 45 days. Once the price of ABC stock moves close to the exercise price of the option at 75, both stock and option will usually move together, often in small fractions of a point. Thus, the $270 investment can be just as profitable in absolute dollars as the $7,453 investment (not counting any dividends ABC might declare in the next 45 days).
What I find most interesting about the options market is that a single trade involves both investment and speculation. When options are used to protect positions or to acquire stock, as part of an investment strategy, the other side of the trades in these puts and calls are speculations. So, one side of the trade is investing in the traditional sense and the other is speculating.
That means investors who participate in the options market also have to know how to trade. After all, if you wanted to drive your auto off the highway onto the racetrack, you ought to first know a few more things about driving.
Because of the time factor, simply buying call options can be risky to the speculative investor unless you know how to trade both the stocks and the options on the stocks. When the price of the stock declines, the value of the call option can drop faster and farther percentage wise than that of the stock and, probably, will expire worthless.
So you have to be careful when speculating with calls. And, as the broad market tends to move up say 85% of the time, you have to be careful buying puts as well.
Selling (writing) calls on stocks you own can be a conservative strategy however. With experience, a knowledgeable broker and a good market, I believe a call writing investor should obtain total returns at an annualized rate, of 18% to 20%, which would be 13% to 15% from premiums and 3% to 5% from dividends (as long as the stock is owned and used as collateral rather than cash. But, even with cash for margin you are going to earn interest on your credit balance).
Trying to figure out options premiums
When a stock trades at its exercise price, the options premium percentage as a percentage of the underlying stock price will vary simply depending on the volatility of the stock price. This is the table I use to explain the options premium percentage differences of low, average and high volatility stocks:
Insert table
So, for a very volatile stock, I would expect to pay a premium, as a percent of the price of the underlying stock, in the range of 10% to 11.7% for an option with 3 months to expiration. If the stock is not volatile at all, I would expect the premium to be in the 3.3% to 5% range.
There are two other considerations regarding options I'd like to cover at this point:
(1) Dividends and rights: As long as you own the stock, you continue to receive the dividends. That's why calls for stocks with high yields sell at lower premiums than those of companies with small dividend payouts.
A stock dividend or stock split automatically increases the number of shares covered by the option in an exact proportion. If a right is involved, its value will be set by the first sale of rights on the day the stock sells "ex rights".
(2) Commissions: These depend on your broker-dealer. Here is the Interactive Brokers commission schedule.
Writing call options
Writing (i.e., selling) calls is an investment strategy for conservative investors. It is not a speculation. If you think it is because of the risks involved, then by your definition all investing must be speculating.
In writing calls, you start off with an immediate and certain profit rather than an uncertain, potentially greater gain.
You have three choices. You can trade them on-the-money, in-the-money or out-of-the-money:
(A) On-the-money calls
These are written at an exercise price that is at or close to the current price of the stock.
Example: In our first case study, on November 5, Mr. Smith buys 100 shares of ABC at 74.50 and sells a May 2004 call at a striking price of 75, for 5.50 ($550). The buyer acquires the right to buy this stock at 75 anytime before the expiration date near the end of May.
Mr. S will not sustain a dollar loss until the price of ABC goes below 69. He will probably not have the stock called away from him until its price moves above 80.50.
Let's see how the trade might work out for both sides.
By May, say ABC has moved up from 74.50 to 82 (i.e., 10.1%) so the call option is now well in the money. The buyer can exercise his option, pay $7,500 and acquire the shares from Mr. S that are now worth $8,200. After deducting about $600 costs (i.e., the $550 premium paid to Mr. S plus two commissions), he will have a net profit of $100, which increases his capital over 6½ months by 18.2% (i.e., 100/550) on this small trade. This call buyer was able to take advantage of the leverage of options.
But if the price of ABC moves up to only 77.50, the call buyer will take a loss of $350, while Mr. S will keep about $615, which is the $550 premium plus two quarterly dividends of about $37.50 each, minus a $10 commission paid on the call sale. On an investment of $7,450 plus $10 commission, Mr. S then made (615/7460) 8.3% for a 6½ month investment, which is about a 15.25% annualized return.
Typically, the call would have been exercised earlier, resulting in a much higher annualized return.
If the price of ABC soars to the mid-80's or higher (really how high can stable ABC go?), Mr. S would lose out on the gains he could have made by not selling the call against his position but isn't he going to be satisfied with a return of 16% to 24% per year?
If the price of ABC falls, the call option expires worthless. But Mr. S has applied that $625 gain against his cost of ABC, which lowers his cost base to $68.25. In fact he can write a new call against his position after the first one expired. Over a period of years, Mr. S can do quite well with call premium income and dividend income in his relatively stable stock.
With all calls, there's flexibility and, often, several alternative strategies.
(B) In-the-money calls
This is a more aggressive technique that requires close attention but can result in fine profits and tax benefits for those in high income-tax brackets. The calls are written below the current stock price.
Example: You buy DEF at 209 and sell two in-the-money calls, at a striking price of 200, for 25 ($2,500 each). If DEF goes to 250, you buy back the calls at 50 ($5,000 each), take an ordinary loss of $5,000, then sell the shares for a $4,100 gain. In a 50% tax bracket, the loss saves $2,500 in taxes, and the after-tax gain is $3,280.
If DEF declines, there are no ordinary losses for tax purposes. But you can still make money if the stock ends its option period between 209 and 185. Between 209 and 201, everything is a capital gain. At 201, if the call is exercised, there's an initial $5,000 capital gain. You must deliver the shares for an $800 loss and can buy another 100 shares at market for another $100 loss. But the net is a satisfactory $4,100 -all taxable at the low long-term rate.
At 200 or lower, the calls are worthless, so you pocket $2,500, after taxes, as ordinary income. From this, deduct the $900 loss on the stock for a net gain of $1,600.
(C) Deep-in-the-money calls
These are calls that are sold at striking prices below the current quotation of the stock Writing them is best when the investor is dealing in large blocks of stock because of the almost certain commissions that have to be paid when the underlying stock is called. The best selection is a dividend-paying, low-volatility stock of a well-known company like SBC, a Dow 30 stock which yields about 5.29 percent (February, 2005). The call seller always accepts a certain, limited profit rather than a potentially bigger gain.
There are two approaches:
(1) Using the leverage of options: when the exercise price of the call is below that of the current value of the stock, both securities tend to move in unison. Since the options involve a smaller investment, there's a higher percentage of return and, in a down market, more protection against loss.
Example: GHI stock is selling at 97.63. The call price at 70 two months out is 28, so the equivalent price is 98. If XYZ goes to 105, the call should keep pace and be worth 35.
If you bought 100 shares of the stock, the total cost would be about $9,800. Your ultimate profit would be about $550, close to a 5.5% return. If you bought 10 options, the dollar profit would be a 22.4% return on the smaller $2,900 investment. If the stock does not move, you can let it go or buy back the calls at a small loss. If GHI declines, your maximum loss is $2,900, probably much less than that of the stock.
(2) Creating cost: basing your return on the total income received from the premium and dividends. Example: In January, you buy 1000 shares of JKL stock at 39.50. You sell April 35 options for 6.88 each, thereby reducing the price per share to 32.63. There's a 45¢ per share dividend due before the exercise date.
If the call is exercised, the total return will be $7.33 on a $32.63 investment, which is a 22.5% gross profit in four months. Even after commissions, the annual rate of return is excellent, and the JKL stock will have to drop below 33 before there's a paper loss.
(D) Out-of the-money calls
These are written at exercise prices well above the current quotation for the stock. They are best suited for investors who want to combine modest income and capital gains and still retain ownership of the stock.
Example: In March, Mr. S buys 300 shares of MNO at 50.50, then writes three October calls, at the striking price of 60 at 1 ($100) to get $300 immediate income.
If the MNO stock stays below 60 for the next seven months, he keeps the premiums, dividends, and stock and writes new calls.
If MNO goes above 60 before the end of October, Mr. S can protect his position by buying back the calls just before the exercise deadline. He will have to put up cash to do this but, like he did with MNO, he will keep the stock with its 9½ points of unrealized gains. By repeating this process, he will strengthen his portfolio and add to his income.
This approach has risks:
(a) in a rising market, such good deals are hard to find because the price of the stock must have declined sharply and quickly in order to have the 60 option still listed;
(b) the stock may move up just as rapidly and be called before the expiration date;
(c) the price of the stock may continue to drop. Mr. S takes in cash but has paper losses.
Still, with quality stocks, the risks of substantial declines are small if calls can be written again and again, as explained earlier.
Writing naked calls
If you maintain a substantial margin account and have experience in trading options, you can write "naked" calls (that is, selling calls without owning the stock). This can be risky if the stock is volatile and could move up substantially.
But with options, you can always cover your position by buying another call even though it's at a higher price than that at which you made the sale of the option. You will lose part, or all, of your premium but will keep the stock and its paper profit.
When you write an option, you are betting that the stock will not fluctuate greatly, that is: (a) it will not go up by more than the amount of the premium (if the exercise price is below the present market price) or
(b) it will not go up beyond the exercise price plus the amount of the premium (if the exercise price is above the present market price).
Guidelines for writing call options
(1) Be disciplined. Have a minimum of $25,000 in securities and be ready to write options every month or more often if the situation looks unusually promising. Don't have all your money in the same types of securities and try to space the dates on which the options can be exercised.
(2) Set a target rate of return. If you want a 15% annual return, you will have to wait for premiums of over 10% for six-month contracts or 6% for three-month expiration dates. The dividends and turnover will bring such income.
Unless you are very confident in correctly assessing the stock price trend, it's wise to start thinking about getting out if and when you double your money or can buy back the option at a net cost half of that of your investment. For instance, If you bought a call at 1, get ready to sell at 2.10 (the extra amount to pay for commissions). If you sold a call at 4, buy it back when its value drops below 2. You can possibly make more if you hang on but, in today's volatile market, that's possibly too risky.
(3) Focus on stocks you'd like to own based on their merits.
(4) Try to write long-term calls (six to nine months) until you are experienced. The longer the option period, the greater the percentage of premium. With most stocks, profitable changes require at least four or, in erratic markets, six months.
(5) Keep your capital fully employed. Well before your option's expiration date, be ready to sell another one. You are dealing in percentages, so keep those premiums rolling in. Except in a roaring bull market, the odds are that you will retain the stock.
Have a list of ten stocks: five in your portfolio, five others for replacements. Generally, the premiums move with the price of the stock.
(6) Own the stock on which you sell a call. When you become an expert, you can buy the stock immediately after you write the option. Before then, don't try to outsmart the professionals.
It's best to buy the stock and then wait for a profitable option. Once you have decided that the stock is fairly priced or, better yet, undervalued, wait for a temporary dip to buy. Then be patient and don't write a call until you know the total percentage return you want.
(7) Calculate your net return. Commissions can add up.
(8) Don't average down. Gamblers on a losing streak double up. If they bought an option at 4 and it drops to 2, they double up to get an average cost of 3. Now the option price need only move up one point to get out even. If it zooms, they make more money. But like most theories, this sounds better than it is. The markets are not random. A trend in motion is more likely to continue (in this case, down) than to reverse over the short life of an option.
(9) Keep a good bookkeeping system. Options can become frequently traded, so good records make it easier for your accountant to prepare your annual tax return and to provide corroboration if you are audited.
(10) Be persistent. Once you have decided that you will write options as part of your investment plan, keep on doing so regularly regardless of what the stock market does.
(11) Watch your timing. It's best to write a call when the stock has risen to a price that you think is too high. If you bought the stock at 50 arid it has moved to 65, look for a setback. Then write an out-of-the-money call at an exercise price of 60. If you can get a 4-point ($400) premium; you gain downside protection to 61. If the stock is called at 60, you still do well: a 10-point profit in the stock plus 4 points on the call for a total $1,900 return plus dividends.
Timing is also a major factor in the value of the option premium. The closer the expiration date, the lower the premium. In July, premiums on January calls will be one half a point or more less than premiums on comparable February options. The reason: the demand dwindles because investors looking for gains are beginning to move out of the market. This leaves fewer buyers, primarily short-term speculators, to make the market.
(12) Look to protect your capital: When the price of your stock has dipped below your net-after-premium price: (a) sell the stock and simultaneously buy a call with the same striking price and expiration date as the one originally sold (this maintains most of your capital for reinvestment); (b) buy a call to close out your position and write a new call for a more distant expiration date. (See the example of Mr. S earlier.)
(13) Use margin. Leverage boosts profits. Under present regulations, stocks can be purchased on 50% margin. Since long-term call premiums run up to 12%, buying the stocks on margin makes sense. If the stock price is unchanged or declines by expiration time, the option buyer loses his entire investment. If the price rises 12%, the cash buyer comes out about even. But if he uses margin, he has a 24% gain (ignoring commissions and interest costs).
(14) Watch the record dates of high-dividend stocks. To capture the large dividend, a nimble trader may exercise an option that appears comfortably above parity.
(15) Define your investment goals.
(i) If you want maximum safety, write calls on stable stocks that pay sizable dividends. In the Dow 30, that would be MO, T, SBC, and GM. The lower premiums will be offset by higher yields.
(ii) If you want greater total returns write out-of-the money calls on stocks that pay modest dividends and are moving up in value.
(iii) If you want to be aggressive, concentrate on volatile stocks where the dividends are low and the market action volatile. The premiums will be high, but the odds are that in an up market the calls will be exercised and you'll lose your stock. Or, in a down market, the price of the stock will decline for a paper loss.
Writing put options
Writing (i.e., selling) puts is an investment strategy (not a speculation) used by pro-active investors. It's a way of trying to make something happen and if it doesn't, you get paid anyway.
In writing puts, you receive an immediate profit but, until the expiration date, you must be ready to buy the stock if starts selling at or below the exercise price. Maybe that's your objective. If so, it's a good strategy because it provides income and also the opportunity to buy stocks at below current prices.
Most traders write puts against cash (unless they have a lot of marginable high dividend-paying stocks). These are naked options, so you must meet substantial margin requirements and probably have readily available assets of $25,000 or more.
Example: PQR stock is at 53 and you like it but will only buy at a lower price. You think it will probably stay level or go higher. You hope that it falls to your mental price level. So, you write an in-the-money put at 50 and receive 2.25 ($225). If you guess right and the value of the stock remains the same or rises, you earn the $225 income from the premium and nothing else happens as the put you sold expires worthless.
As long as PQR stock stays above 50, the put will not be exercised. But once it falls below 50, you must be ready to buy the stock (or buy a comparable put). If the stock falls to 49, you will have the 100 shares of stock put to you at 50. But, while you have to pay $5,000, your cost is reduced by the $225 premium income, so your net cost was 47.75.
This is an excellent strategy for patient investors who have the cash resources available to bottom pick markets. The problems start when you write puts right at the onset of a bear market as one of my Vancouver partners did in the Spring of 2000. In our example, PQR probably fell through the 47-50 level on its way to 25-30. If you wrote a lot of puts in 2000, you unfortunately bought a lot of stock losses.
Guidelines on writing naked puts
Writing naked puts is approximately the same risk as writing covered calls. But selling the puts has the following extra advantages:
(1) lower commissions because, unless you are writing out-of the money calls, you must include the cost of selling the stock when called,
(2) less margin money than needed to write the same amount of covered calls, and
(3) when cash is used as margin, you may get a higher yield on your money from the broker-dealer than you receive from dividends on stock. If the broker pays LIBOR less half a point, then you probably are earning about 2.5% in 1Q05. You're not earning the dividend tax credit but if a lot of your stocks are in the 0-2% yield range, then you might as well be in cash anyway.
A conservative investor should only write naked puts if:
(i) the underlying stocks are fundamentally strong
(ii) there are sufficient funds in the account to complete purchases of put stock
(iii) you aren't afraid to buy back puts if you change your mind or the market does it for you.
Buying call options
In some months 90% of all calls (or puts) expire worthless so I guess you can say buying options naked is speculating. This sounds intimidating but in reality most losing options of successful options traders are rolled over before the expiry date.
Still, there are significant risks to buying call option contracts (as opposed to writing), so it's best to buy them in a rising market, and to buy them in the stocks of a rising industry group.
Obviously if you're buying puts you'd want to do that in a weakening market, within an out-of-favor industry group.
There are two broad approaches to buying calls:
(i) Buying long-term, out-of the-money call options at a low premium (usually one or less). By diversifying with three or four promising but very risky situations, you might be lucky to win big enough with one of them to more than offset a loss on another.
(ii) Buying short- or intermediate-term in-the-money or close-to-the-money options of popular, volatile stocks. Example: a call with two months to expiry, a stock within 5% of striking price and a low time premium. If the stock rallies strongly and pushes the premium to double your cost, then sell. If you have three or more options, sell when you have a 50% gross profit. One expert says: "Never pay a premium of more than 3 for a call on a stock selling under 50 nor more than 5 for one trading over 60."
The striking price of the option and the market price of the stock should change by about half as many points as the change in the stock price: for example, if a 30 option is worth 5 when the stock is at 30, then it should be fall 2.50 to 2.50 when the stock falls 5 to 25, and when the stock moves up 6 to 36, it should grow by 3 to be worth 8.
Guidelines for determining how much to pay for newly-listed calls where the time premium is high:
(1) Watch the spread prices. When trading a particular month option, always look at the premiums on the adjacent month options to see if they are in line.
(2) Watch for unusual situations. Normally, the prices of options move with the prices of the underlying stocks. But there are periods when premiums move up and down on their own. Often, call premiums drop more than the related stocks.
Example: In November, when ABC stock was at 23.38, the May 25 calls were quoted at 2.38. By late December, the stock was up a touch to 24, but the option, which, theoretically, should have dropped about 5% with the time factor, fell 16% to 2.
If this unusual spread increases, it might be worthwhile to buy back the call and look for more rewarding premiums in the August calls.
Buying put options
Put options can be bought either for profit or for protection.
A put is the opposite of a call. It gives the option owner the right to sell a specified number of shares (usually 100) of a specified stock at a specified price before a specified date. Puts have the same expiration months, dates, and pricing structure, as do calls.
But a put is a distinct entity. Its intrinsic value increases with a decrease in the value of the related stock. You buy a put when you are bearish and anticipate the market/stock will decline. During 2000-2002, puts became very popular.
Properly handled, puts can extend the range of investment and tax strategies, open new profit opportunities, provide bear market protection and, in fast-moving periods, yield excellent rewards.
Like any option, a put is a wasting asset since its value will diminish with the approach of the expiration date.
As with calls, the attraction of puts is leverage. For a few hundred dollars you can control stock worth thousands. Generally the premiums will be smaller than those of calls because of lesser demand. In a bear market, there are more optimists than pessimists.
The best candidates for stocks involving puts are:
(1) Stocks paying small or no dividends. You are hoping for the value to decrease. Dividends tend to set a floor for stocks as, even in bear markets, yields are important.
(2) Stocks with high price/earnings ratios. These are more susceptible to downswings than stocks with lower multiples. A stock with a P/E of 30 has a lot more leeway for a drop than one with a P/E of 15.
(3) Volatile stocks. These are issues with a history of sharp, wide swings. Stable stocks typically move slowly, even in active markets.
Trading options effectively
The options market opens new opportunities for investors of all types. Instead of risking their money in worthless low-priced stocks, speculative investors can with the same outlay get better action in options of top-quality companies like General Electric. There are also effective trading strategies for conservative and enterprising investors.
Because options are traded in high volume daily, there is instant information, and gains or losses can be taken any time during the life of an option's contract.
Trading is for cash, so there are no margin calls.
The investments are relatively small, the potential is large, and there are always opportunities to hedge.
In short, the option's market is certainly a market to get to know and use.
Once you get the swing of trading options, you should find a skilful broker, do your homework and then start making investment decisions because you will soon see that options-trading is very much an investment strategy.
Like any other investment strategy, always think in percentage terms when trading options.
You can dabble with one or two puts and calls but to really get involved, I'd say you should work with at least $10,000 in capital, spend time enough to make frequent checks and have a fast, reliable daily source of information.
I'd say that if you do not have the time to do your homework and follow the intraday markets, trading options might be too much of a challenge.
I once introduced a young psychiatrist, who was a new money management client, to a speculative options strategy that was designed to focus his attention on the market. Two days after investing $25,000, the account balance was $75,000, but he asked me to move the funds back into his core holdings because he couldn't take the time to focus on such extreme trading. If you have the time to watch developments closely, you can profit nicely.
You can let your profits run, too, but for most investors, the best rule is to set target prices that will produce gains of 10% to 25% (net of commissions), depending on the volatility of the underlying stock and the prospects of the overall capital markets.
The sale of multiple call options against a single stock position can assure extra protection in a decline, added income if the stock levels out and bigger returns when there's a modest advance. This tactic works best soon after a strong market advance, or when there's likely to be a temporary market lull or fallback.
But, don't try multiple writing with volatile stocks. Their rapid price swings can quickly narrow the profit zone.
It's important to have a frame of reference for the value of the option, so follow the market trend, and watch the time factor. Concentrate on volatile, low-dividend-paying stocks.
Checkpoint considerations for trading options
The action of the underlying stock will be the determining factor in options profits and losses, but gains are easier to come by when you check the following points:
(1) Time before expiration. The longer the period before the exercise date, the greater the chance for appreciation. Unless you are sharp, observant, and lucky, it seldom pays to trade in calls with less than two months to run. Profits can be made only with volatile stocks in an erratic market and that's no spot for the amateur.
(2) Volatility. The best ones are options on stocks that swing over 25% in a year. This criterion rules out slow moving utilities and basic materials and favors technology.
(3) Price of the stock. The greatest percentage gains can be made with $20-$50-priced stocks; the lowest percentage gains, with options on stocks costing over $100.
(4) Striking price of the option. This selection depends on your experience and trading goals. Buying deep-in-the-money calls offers the best leverage because their premiums are relatively small.
(5) Yield of the stock. The higher the dividend rate of the stock, the lower the premium of the option, in most cases. For quick-profits, stay with low or no-dividend payers.
Guide to trading options effectively
(1) Buy the option when the market is going down but when you anticipate a turnaround soon. This will give you the benefit of both the temporary and long-term price rises.
(2) Buy options where the underlying stock is trading below, but close to, its striking price. The premium will be smaller and will rise when the stock moves above the exercise price.
(3) Pick options with small premiums and the stocks appear to have prospects of fast, upward action.
(4) Stick with high-quality stocks until you are experienced. With options, the risks are enough without adding the danger of poor investments.
(5) Don't enter market orders unless you are in a fast moving market. Give your broker a specific price or, at least, a price range at which to buy. In fluctuating markets, an active option can move more than a half point and can cut deeply into your potential profits.
Mistakes with options
(1) Failing to include all costs in calculating profits. Since the profit from writing calls is always limited, be sure to consider commission costs.
(2) Being too bullish. No matter what your long-term forecast for the stock market, it will undoubtedly have little effect during the short life of most options. Over the short term, it is just as likely that the market will go down as well as up. This applies especially to buying options. So, never put all your money in options on one side of the market.
(3) Forgetting loss potential. When selling calls, your profit is limited but your potential loss is almost unlimited if the stock goes down. Use a stop-loss order to sell the stock when it has declined to a predetermined price. At that point, the call can be continued naked or bought back.
Summary of option strategies, in order of risk-reward level, according to one's outlook for the underlying stock
Very Optimistic:
* Sell put with strike price above market
* Sell put with strike price at market
* Sell put with strike price below market
* Buy call with strike price above market
* Buy call with strike price at market
* Buy call with strike price below market
* Buy stock on margin
Moderately Optimistic:
* Buy stock, sell put
* Buy stock, sell call with strike price above market
* Buy stock, sell call with strike price at market
* Buy stock, sell call and put, both at market
* Buy stock, sell call and put, both with strike prices away from market
Neutral:
* Buy stock, sell one call with strike price above market, one at market
* Buy stock, sell two or more calls with strike price above market
* Sell put and call both with strike prices at market (straddle)
* Sell call with strike price at market, put with strike price below (combination)
* Buy stock and one put with strike price at market (call)
Moderately Pessimistic:
* Buy stock and two puts
* Sell call with strike price at market or lower, buy call at higher strike price (bear spread)
* Sell naked call with strike price above market
* Sell stock short, buy two calls
* Sell stock short, buy one call at market (synthetic put)
* Sell naked call with strike price at market
* Buy one call and two puts, all with strike price at market
Very Pessimistic:
* Buy put with strike price at market
* Sell naked call with strike price below market
* Sell stock short, buy call with strike price above market price (partial put)
* Buy put with strike price below market
* Sell stock short
Posted by Bill Cara at February 4, 2005 3:04 PM
