Getting Started with Options
By: George Angell
The following is an excerpt from George Angell’s Small Stocks, Big Profits
Options trading can be an extremely lucrative undertaking, but you must understand the risks involved. For most newcomers to the game, options might seem a dream come true. For a couple of thousand dollars you can buy up options in Microsoft, Motorola, Disney, and even Google and profit in all the gains of the underlying stocks. And the potential profits can be dramatic. A few years ago, I was able to buy Disney call options for just $2 per option. Several months later, I sold the Disney calls for $10 each – a five-fold increase in my money! More often than not, however, the underlying shares don't move, however. This means the option buyer is looking at a loss of all his invested funds or at least a portion of those funds. Having said this, you must always be cognizant of the risks involved when you buy options.
If option buying is risky, what about selling them? That's right, just like in the stock market; there is a seller for every buyer. Actually one individual may sell thousands of options to many, many buyers. This one-to-one ratio is not important. What is important is that you recognize that someone is betting against you when you buy an option. The sellers job is to perform on his end of the contract, namely to provide you with the stock at the strike price if you decide to exercise your option. At a practical matter, you will almost never actually exercise the option; nine times out of ten, you simply sell the option in the options market.
When you purchase a call, you purchase the right to buy the underlying stock at the strike price. The seller, therefore, must agree to provide you with that stock. You, the buyer, pay a premium to the seller for this privilege. The premium therefore, is income to the seller of the option and a cost to the buyer. Regardless of what happens in the days subsequent to the sale of the option, the seller gets to keep the premium. He therefore gets a fixed return when he sells an option. When you first enter into this agreement to buy an option, the transaction is known as an "opening" transaction. When you decide to get out by selling the option, the transaction is known as a "closing" transaction. Once you have both bought and sold, the option ceases to exist. Likewise, from the seller's prospective, when he buys back his "short" position, his liability ceases to exist.
Now we have discussed how a buyer has a fixed cost and unlimited potential. What about the seller? The seller has the very opposite. He has a fixed and known income from selling the option and an unlimited liability since the underlying stock (in the case of a call option) can soar to infinity. Why, given those odds, sell options? Paradoxically enough, the seller often gets the better part of the deal. He has income whereas the buyer has an expense. The buyer, in order to profit, must see an appreciation in the price of the underlying security. If the stock doesn't move, the time value inevitably goes to zero. Most new options buyers expect the market to move. All too often, however, the stock languishes or goes in the other direction. Finally, the seller must perform by posting "good faith" margin money with his broker on a day-to-day basis if the options he sold prove profitable to the buyer. By seeing that the option is "marked to the market" daily, the trading exchanges ensures the integrity of all their contracts.
The one word that best applies to options is "versatile." There are an unbelievable number of sophisticated strategies utilizing options. You can use strategies often to "hedge" your stock portfolio, for instance. If you own IBM shares and fear a downturn, you can buy IBM puts to protect yourself – and keep the stock to boot! You can "spread" options in which you buy one strike-price call and sell another strike-price call. These can be either "bull" or "bear" spreads and can be puts or calls, or both. You can spread options between expiration months, buying July calls and selling September calls. You can do what is known as "ratio" writes, when you sell twice as many calls as you buy – or vice versa. All these strategies have their time and place. But the basic strategy is simply to buy calls when you think the market is about rise and buy puts when you think lower prices are ahead.
There are options available today on a remarkable number of stocks and indexes – even commodities, precious metals, and petroleum futures. In the traditional stock options, you actually received the underlying stock. But if you prefer to trade a basket of stocks, you can buy options on the OEX S&P 100 traded at the Chicago Board Options Exchange and the popular S&P 500 index traded at the Chicago Mercantile Exchange. When you are dealing with stock indexes, there is no actual delivery of stock, only a "cash" payment at the end when the option actually becomes the cash index. These products were developed to help large institutional investors to hedge their portfolios. But because of their enormous liquidity, they have gained a large following among small individual investors.
Looked at from its most basic strategy, call buying is the primary focus of most small investors. People don't like to bet that stocks are going down. For one, a stock can only fall to zero; for another, the potential of capturing a bonanza are far greater when you purchase calls. The cost of buying a call option is relatively small. The problem is, of course, you must be correct not only about the direction the market or stock will take, but also correct about its timing. While call buying can be very profitable, it can be frustrating in the sense that you can be correct on the stock but wrong on the timing. Not so many years ago, I can remember aggressively buying 10-strike calls in Motorola (MOT). The stock was struggling and couldn’t stage the rally. Today, Motorola is trading above 20. But this is little consolation since the call options have long since expired worthless. In looking back at this fiasco, I would have profited handsomely if I'd simply purchased the stock.
As you can see, there are clearly tradeoffs when you decide to utilize options instead of stocks, or vice versa. There are pros and cons to each. But it probably won't hurt if you undertake a small option buying program just to get your feet wet. There is nothing more likely to get your interest then if you have some money at risk. So consider buying several options to see how this strategy appeals to you. You don't have to commit a lot of money to do this. With many good options trading below $5, your out of pocket expenses will be minimal.