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Options 101

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August 10, 2009 – Comments (6)

This post really is for Seano67 upon request from a different thread.  Everyone, however, is welcome to join.  The sole purpose of this thread is to give some basic option strategies for casual investors.  It is by no means definitive.  Simply, simple.

There are basically FOUR trades.  You can buy or sell PUTS, and you can buy or sell CALLS.  A PUT is basically a bet on stocks going down, while a CALL is basically a bet on stocks going up.  Each option covers 100 shares.  1=100shares, 10=1000 shares, and so one (said I was going to be simple here 'p)

You need a STRIKE PRICE.  That is basically your target price.  Company X sells for $20.  You think it will go higher short term but you dont want to pay $20 per share.  Instead you can buy the CALL  with a strike price of $20, but that call may only cost you $1.  That cost is dependent on several things.  Options are a function of time, unlike owning the actual shares.  The more time on the option the higher the premium you pay.  Also the more volatile the stock the higher the premium you pay.  So in our example, you can pay $1 for an August $20 call, or $2 for a September 20 call.  And so on.  The timeframe is up to you, provided they are available by a given stock (not all stocks offer options).  You chose the September 20 call to give your pick a little more time. 

Come September option expiration (basically the 3rd Friday of the month) your stock is selling for $19.  Welp you lose.  But you only lose the $2 and nothing more.  You lose because the CALL gives you right to buy the stock at $20 from the guy who sold you the CALL.  Now there may be a circumstance where you might still exercise it, but we are talking simple here and you would be silly to pay a guy $20 for something you can buy in the open market for $19. The option expires worthless and you only lose that initial investment.

Now come September expiration your stock is selling for $30.  Jackpot!  (ah the heartbreak stories I can tell you about selling calls too soon). Odds are your option is now selling for $10 (the difference between the strike price and the  actual price of the stock).  It is important to sell those BEFORE the market closes otherwise you will be stuck buying those shares covered by the option.  Of course, next monday you can sell them for a profit but anything can happen over a weekend plus you may not have the money.

That is basically it when buying CALLS.  You can play around with what strike price you want and what expiration month. You might do it if you think a stock is going to move higher short term and you want to make greater profits off that call.

If you read my May blogs I kept advising people to buy Calls on BP.  My thesis was May/June tends to be an up month for oil from seasonality and speculation.  BP was trading at around 38.  I chose the July option period to give my call more leeway since my plan was to exit before July 4th. I bought July 40 and 45 calls. As BP rose passed 40 I sold off the 40s and bought 50s. Eventually I closed them all by the time BP hit a little over 52.

While I do own the shares in BP for the long term, I was able to play the short term with alot less money and made a heck of a profit. That is the advantage of buying CALLS.  You spend less money, you risk less, and you do it for a specific timeframe.

Buying CALLS for say a longer time frame can be a cheaper way to buy a stock position for an 18 month time frame too.  I had blogged about buying BAC January $10 2011 calls.  The cost is less than the shares.  I think by 2011 BAC can easily be a 20-30 stock.  I put less money up than buying the shares.  I am tempted to close out the position, at least half anyways, because we may be seeing 20 alot sooner.

SELLING CALLS

There is a way to squeeze some extra bucks out of a long position you own.  That is by SELLING CALLS.  Remember when you bought your calls in our example above, there was another guy on the other end selling you that call.  What that means is he can get his stock "called" away come expiration date should it trade above the STRIKE PRICE.  There are several reasons why a person may sell a call.  One is to make a few more bucks on his stock if he doesn't think it will move much for awhile.  In our example above he made $2 per option ($200 per 100 shares) for those September 20 calls.  If the stock finishes at under $20 the option generally will expire worthless, he keeps that $2.  And he can rinse repeat.  Should the stock close above $20, well he keeps that $2 and gets $20 for his shares for a total of $22.  If he bought it for say $18 then that is a nice profit.

Selling calls in a declining market is another way to make money on stocks you just don't want to sell and you don't want to buy PUTs to protect them (more on that later).  You will basically just keep that $2, but if the stock fell you will need to go out further in the option time chain to get $2 again (something you may or may not want to do).

Be careful on selling calls since you very well may get your stocks called away, screwing you on capital gains treatment.  Do it if you don't care if the stock gets called away.

BUYING PUTS

PUTS forces someone to buy your shares.  It is basically a gamble on the downside.  Say in our example you BOUGHT PUTS with a strike price of $20. If the stock sells for $21 come expiration, welp you lose.  But if the stock is at $18, you profit $2.  The person has to pay the holder $20 on a stock selling for $18.  Remember to sell them BEFORE the market closes.

You buy PUTS for basically two reasons.  You think the stock is going to tank and shorting it is too risky.  So buy puts and your loss is limited to your initial investment.  Or you can buy puts to basically insure your long positions.  You don't want to sell your shares but you really do think a correction is coming.  The PUT protects you if the shares drop since you make up in the PUT what you might be losing in the shares. 

SELLING PUTS

This can be pretty lucrative in a rising market.  When you SELL a PUT you are obligated to buy that stock at a set price, the STRIKE PRICE.  You get the premium for that PUT to keep.  You do this if you honestly don't expect the stock to sell below the strike price or you don't care if you get called to buy it. 

I have been blogging about C and BAC puts as ones to sell.  The kicker is you have to have the money to cover those put shares, so that money gets held up (it is one example where a margin account can help PROVIDED you don't care if you are forced to buy).  My thesis on C is that it is just too darn cheap and the Gov't said it won't let it fail.  It also has a nice international exposure.  I am patient on the underlying shares and have accumulated hard in the $2 range.  I don't mind buying even more near there but it is selling near $4 now.  I am guessing the $2 days won't be happening (unless you think another crash is happening, which I don't).

Now awhile ago I SOLD PUTS on C with a strike price of $3 expiring in
December of this year.  I was getting premiums averaging .75.  Come December if C is over $3, I keep that premium.  If C is under $3 I have to buy for $3 but keep that premium, making my net cost $2.25.  I can, of course wait until December, or I can close out a profit now by BUYING PUTS to CLOSE my position.  But I don't want to because I really wouldn't mind buying them at $3 come December since I have a 10+ year horizon on C.  SELLING PUTs is a great way of making money if you think the market won't decline a ton.  Many people say "I am waiting for a pullback to get in."  Well selling puts is one way to do it.  You get the stock at a discount if it falls enough to be below your strike price, and if the market keeps going up welp at least you made some money as opposed to none waiting on the sidelines. 

There are lots of other strategies for options, but these are the basic four.  If you have any questions Seano67, or anyone else, fire away.

6 Comments – Post Your Own

#1) On August 11, 2009 at 2:13 AM, Seano67 (84.76) wrote:

Oh this is great, man. Thanks for taking the time to do this. I'm gonna pore over it a bit to see if I can't get a handle on the subject, and I will likely be back with questions, cause I'm really not that bright! Haha. ;) Anyway, thanks again.

 

Cheers!

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#2) On August 11, 2009 at 8:38 AM, binve (< 20) wrote:

awallejr, very nice write up! Thank you for a taking the time to do this for your fellow fools. Thanks!!

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#3) On August 11, 2009 at 10:01 AM, awallejr (83.81) wrote:

As a current play on selling puts.  Take a look at the January $12.50 2011 BAC ones.  You can get a current premium of 2.17.  That means you get paid 2.17 which you forever keep but you obligate yourself to pay 12.50 per share of BAC come January 2011.  Worse case is BAC sells for under 12.50 and you have to buy it (but your net cost is 10.33). Best case is BAC sells for more than 12.50 come January 2011 and you just made 2.17 without buying anything.  In the interim you can always close out the option position for a profit too should BAC keep rising and as time passes since the cost of the put will continue to decline.

The above assumes the stock and the market will not crash again by 2011.

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#4) On August 14, 2009 at 12:05 AM, ChrisGraley (29.89) wrote:

Great post awallejr! Maybe a warning about naked calls is in order though.

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#5) On August 14, 2009 at 12:18 AM, awallejr (83.81) wrote:

Thanks. Thought it was there in that I mentioned it was a time sensitive investment unlike owning actual shares.  And yup, people can lose their total investment on naked calls if they are wrong about the short term move. 

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#6) On August 15, 2009 at 12:09 AM, awallejr (83.81) wrote:

Although upon further clarification, SELLING naked calls can be extremely dangerous and I wouldn't advise it.  I remember being tempted to do it with Google May of last year the day before option expiration.  I was going to naked sell like about 50 Google calls 50 points out of the money.  I honestly didn't think Google would possibly move that much in one day. I almost hit enter until I remembered Google was announcing their earnings close of market so I didn't go throught with it.  After close Google announced great earnings and the stock eventually moved up over 80 points.  I would have been creamed. 

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