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Subject0:
Trading Stock Options: Good or Evil?
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Date: 01 Mar 2007
Time: 06:55:11 +1000
Remote Name: 91.124.147.113
Trading Stock Options: Good or Evil?
by: Kerry W. Given, Ph.D.
i
You have probably heard people refer to options as a risky enterprise, akin to
gambling. And it is true that options trading can be very risky, especially when
engaged in with minimal knowledge and preparation. The average stockbroker or
financial planner does not have sufficient options knowledge to guide you in the
use of options in your portfolio. But that doesn�t mean options cannot play a
role in a conservative portfolio of stocks.
The majority of today�s options trading volume derives from institutional money
managers who use options to protect their clients� stock portfolios. They are
using options as insurance. Options may also be used to boost the income that
may be derived from a conservative stock portfolio.
Options written on stocks are referred to as equity options and come in two
forms: calls and puts. A call option gives the holder of the option the right to
buy the underlying stock at the strike price of the option at any time before
expiration. A call option is similar to a grocery store coupon for a five pound
bag of flour at an attractive price; but the coupon is only good for 30 days and
is limited to the purchase of one five pound bag. Similarly, a call option gives
you the right to buy 100 shares of stock at a specific price and it is only good
for a particular period of time.
Put options are opposite in character to calls and are more like insurance; a
put option gives the owner the right to sell the underlying stock at the strike
price of the option any time before expiration. Put options are often purchased
when one expects a stock to decline in price, or it could be used as a form of
insurance if I already own the stock; if my stock declines in price, my put
option appreciates and compensates for a portion or all of that loss. An
excellent analogy is house insurance; if I pay my insurance premium January 1
and nothing happens to damage my house this year, my insurance expires
worthless, just as my put option will expire worthless if my stock just
continues to appreciate. But if a hurricane damages my house during the year, my
insurance pays for some or all of the repairs. Similarly, if my stock declines
in price, my put option will increase in value, replacing some or all of the
loss in my portfolio.
Equity options expire on the Saturday following the third Friday of each month.
It is common to hear or read that equity options expire on that third Friday.
While that isn�t technically correct, it is true that Friday is the last
opportunity to trade those options. Saturday expiration was established to give
the Options Clearing Corporation and the brokerages time to settle their
customers� accounts before the options technically (legally) lose their value.
Consider Hewlett Packard (ticker symbol: HPQ) as an example. HPQ closed May 28,
2009 at $34.70; the June $35 call option was quoted at $1.00 at the close. In
the options quotations on a site like Yahoo Finance, you will see bid and ask
prices posted. The Ask price is the price quoted if I wish to buy the option,
while the bid price is what I would have to pay to sell my option. Options are
quoted per share of the underlying stock, but are sold as contracts that cover
100 share lots of stock. The HPQ June $35 calls are quoted at an ask price of
$1.00. Each contract is priced at $1.00 per share of the underlying stock; since
each contract covers 100 shares of stock, the contract costs $100 and five
contracts would cost $500. I have the right to exercise my options anytime
before they cease trading on Friday, June 19, and buy 500 shares of Hewlett
Packard stock at $35 per share or $10,500. Or I could simply sell my call
options at the bid price anytime before expiration.
Options can be used in several very conservative ways in a stock portfolio. For
example, if I own 300 shares of Hewlett Packard (HPQ), but I am concerned this
market is softening and may take another dive downward, I could buy three
contracts of the June $35 puts at $1.40 to protect my position. This put
position would cost me $420 and protect me through June 19. As HPQ drops in
price, the puts will increase in price, compensating for some or all of my loss
on the stock. This is called a �married put� position. However, there is no free
lunch in the market; if HPQ trades sideways or upward, I will lose my $420 of
�insurance premium�.
Another conservative use of options is the �covered call� strategy. If we
continue with our example of HPQ and I think the stock is going to trade
sideways or slightly up over the next few weeks, I could sell three contracts of
the June $35 calls for $1.00, bringing $300 into my account. If HPQ is trading
unchanged at $34.70 on June 19, the $35 call options will expire worthless, and
I will have gained $300 or 2.9%. But if HPQ trades upward of $35, my maximum
gain is capped at $330, or 3.7%.
Options trading can be very risky when used in a speculative manner, but options
may also be used in conservative fashion with a stock portfolio, both protecting
the downside and also increasing the income from the portfolio.
About The Author
Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years of experience
investing in the stock market and over seven years experience trading equity and
index options. He has taken many classes on investing and trading through the
years and has discovered first hand how difficult it can be to separate the
financial facts from the marketing hype, myths, and get rich quick schemes. He
can be reached at: http://www.ParkwoodCapitalLLC.com
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