Options a primer
Oooh. Options, scary options. Spooky Scary Options. Well, let me tell ya Pilgrim. They ain’t that scary and they are a very effective trading tool. There are a lot of ways to use options.
You can protect a current position with options. You can benefit from a rise in an equity price without having to buy the underlying stock. You can buy a stock below its current price.
Let’s say your not Warren Buffet and your biggest concern in life is how to invest 43 Billion in cash. In fact let’s say you only have 1,000 left in your portfolio in cash and want to get it working. You could buy 2 shares of Google. Or you could buy 5 shares of AAPL. Or you could buy about 50 shares of Ebay. Or you could buy 10 shares of NCR.
Call options allow you the right (not the obligation) to buy those stocks at a future price on a future date.
Let’s say you love love love EBAY. (Never love a stock, when they are done with you they never call never write.)
It is currently selling for 23.50 a share. You want to own more EBAY that your 1,000 dollars will allow. What to do? Mmm. Let’s say that because of all the homework you have learned to do by reading Cramers’ Books and from this incredibly informative blog, you know in your heart that EBAY will be at 30 by the end of March 2010. Here is what you can do.
Go to your broker’s website or Google Finance or Yahoo Finance and look at the link that says Option Chains. Specifically you want a “call option” for April 2010. There you will see a whole bunch of options. Look for the “strike price”, (this is the price you are buying the right to buy the stock) a couple of dollars below the current price of 23.50. let’s focus on the 22.00 strike price. Today, (remember it was a good day in the market and call options rise and fall with the market), the April 17th 2010 call option to buy EBAY at 22.00 would cost you $2.83 a share for an option contract. A contract controls 100 shares. So for you to have the right to own 100 shares of EBAY at a price of 22.00 a share, it will cost you $283.00. That’s right, what would typically cost you $2,350.00 you can control for $283.00.
Now do the math. When do you make a profit? You paid $2.83 to own EBAY at 22.00 a share. I’ll wait. Got it. You are “in the money” when Ebay hits 24.83 (22.00, the stike price plus the premium to buy the stock of $2.83). At that point you could sell your option and break evenish. Now let’s say you are right and the stock start its break for 30. In March let’s say EBAY is selling for 28.50 a share. You have the right to buy those shares now selling for 28.50 for 22.00 each. Guess what your option is worth? I’ll wait. Yeah your option that you bought for 2.83 cents is worth about $6.50 or more because it is getting close to the expiration date. You have just made a 267% profit. You sell the option count your money and enjoy a nice bottle of single malt.
Can you loose money on a call option. Sure I have done it many times. Here is what happens. Let’s say you bought the April 17th EBAY option of 22.00 for 2.83 cents or $283.00. And Glyde (Keep an eye on this one it could do to Ebay and Netflix what Netflix did to Blockbusters), catches on faster than everybody imagined and EBAY gets down graded by everyone and his mother. The shares of EBAY get whacked to 11.00 a share. Your option to buy the shares at 22.00 don’t look to hot. But there is always a bigger fool out there so they might not be worthless. But let’s say they are and you let the option expire in April you lost 283 dollars. Sorry. But imagine you had the money to buy the stock. You would be down about 1200 bucks and still crying in your cheap beer.
Do some research. Call options are a great way to leverage your portfolio, and get ahead of the game with less cash than you need to actually own the underlying equity. And, yes you can put stops on options but flying through stops on options happens a lot more than flying through stops on stocks.