Prosper Newsletter: April 2008 > Stock

You understand that the following information is educational in nature and is not intended to be legal, accounting, or tax advice. You are responsible for your own financial decisions and should consult your own legal, accounting, and tax advisors before making your financial decisions.

Trading Options

Keeping the Right Mix

The word option can often be misleading. Your neighbor may talk about exercising options. The television financial people buzz about trading options. The newspaper headlines use the word to predict market changes. What exactly are options? More importantly, how can you start trading them?

There are, in fact, three main types of options: employee stock options, over-the-counter options (OTC), and exchange traded options (or listed options). Not surprisingly, they are all very different, but they do have one thing in common: options serve as a contract between two parties.

This time of year you are likely (or should be) thinking about spring-cleaning. How do you clean up and decipher between options? Let's start with employee stock options. These options are granted to employees as a type of reward, incentive, or compensation. Generally, an employee exercises the option if the company agrees to sell them stock at a price below the market rate. Typically, these options cannot be sold, they are only for you.

Over-the-counter options (OTC) are traded between two private parties and are not listed on exchanges. Therefore, they are not restricted or regulated by any exchange. They can become very complicated. The parties involved are generally large corporations, syndicates, and/or extremely well-connected private individuals.

Exchange traded options (or listed options) are traded on the exchanges and have very standardized contracts. An exchange publishes ongoing, up-to-the-minute market prices and serves as an intermediary to both parties of a transaction. These are the options you hear about most and include stock options, bond options, futures contracts, commodity options, and index options. For most traders, the exchanges provide the best protection and fluidity. The exchanges back the contracts, maintain the anonymity of the parties involved, regulate the market, enforce fairness and transparency, maintain order, and enable fast-paced trading.

There are six primary components that nearly all options contain:

• The option holder's position—the right to buy (call option) or the right to sell (put option)
• The defined amount and class (1,000 shares of ABC's preferred stock)
• The strike price—also known as the exercise price
• The expiration date or expiry
• The settlement terms—how the asset is to be delivered
• The market quoted terms—to translate the quoted price into a premium amount

There are four basic types of trades—long call, short call, long put, and short put. A long call is when a trader buys the right (a call option) to purchase a stock that he or she thinks is on the rise. He or she buys the right to buy a stock (not the actual stock) and pays a premium. The trader has no obligation to buy the stock, just the right to do so until the expiration date. If the stock price increases more than the premium, he or she will make money. If it decreases, the contract can expire and the trader only loses the premium paid.

In the case of a short call, the trader believes the stock price will go down. He or she short sells the stock or sells a call. The trader selling a call is obligated to sell the stock to the call buyer at the buyer's position. If the stock decreases, the short call makes a profit on the premium paid by the buyer.

Long puts are where a trader thinks a stock will decrease and he or she buys the right to sell the stock at a fixed price—a put option. He or she is under no obligation to sell the stock, but has the right to do so until the expiration date. If the price dips below the premium that he or she paid, then the trader makes money. If the stock increases, the trader just lets the contract expire and loses the premium.

When a trader feels a stock will rise, he or she can either buy the stock outright or sell a put. If the trader sells a put, he or she is obligated to buy the stock from the put buyer at the put buyer's option. If the stock increases, the short put will profit off the premium. If the stock decreases, the short will lose money—potentially as much as the full value of the stock.

There are many possibilities with options trading. As you conduct your spring-cleaning, make sure you have the right mix of options. Clean out stocks you don't need and focus on the options with the most upside potential.

Stock Mix

Another month has come and gone with more volatility in the stock market. The worst thing about all this volatility is a lack of direction. The market has been going up a day or two and down a day or two. Times like these are challenging for even the most seasoned investors.

This is a good time to sit back, evaluate your current positions, and do a little spring cleaning if needed. Take profits while you have them. Don't hang on to trades too long, or you might see your profits wash away quickly. Be patient and wait for the perfect scenario when purchasing a stock or option. Remember, it's better to be out of a trade wishing you were in than to be in a trade wishing you were out. You won't ever lose money in the market by taking profits. Even small profits are money in your account, and making money is what it is all about.

We are approaching a time of year when a lot of people do their spring cleaning. This is a great time to review your watch lists and take out the stocks that have been underperforming, replacing them with new and better stocks. Look for sectors that have really been beaten up in the last few months. Start monitoring them closely for signs of coming back.

The stock market is in an oversold position. When investors start to gain confidence in the market again, you will see these sectors rise sharply. However, don't be surprised if the market remains volatile for awhile longer. There may still be more bad news to come from the financials. Be patient and wait for just the right time. A good spring cleaning may be just what you need to get back on track, or to take advantage of the profits ahead.

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*See the Elective Class Catalog in your Success Center for the latest dates, times, and class details.

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