Prosper Newsletter: September 2007 > 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.

Because Everyone Wants "Options"

Months ago, stock traders and investors were touting how strong the market was only to find that it took a significant turn in recent weeks. Such is name of the game; the stock market is volatile and full of risk. Yet, there are ways to limit your liability and leverage your money through buying and selling options.

First introduced in the 1970s, options are a relatively new tool that allows investors to make trades as if they were buying thousands of dollars of stock, only with less risk and increased flexibility. However, many novice traders do not understand what options are, their benefits, and how they work.

Simply put, an option is a contract to buy or sell shares of a specific stock at a specific price and time. To which you may ask "so, what is the difference between an option and stock?"

Though they function similarly in the sense of buying and selling power, an options contract grants an individual the right, but not the obligation, to buy or sell a stock on a pre-determined price at a specific date or time. In other words, when you purchase an option you are buying control of a company's stock, whereas if you buy a stock you are purchasing company equity (or a portion of ownership in a company). With that, options may be used to profit, in a variety of ways, from a rise or fall in the underlying equity. And, if used properly, options can be less risky than simply buying stocks. Additionally, options can provide significant financial leverage by enabling you to control the shares of a specific stock without tying up a large amount of capital in a trading account. Moreover, options can be used as insurance policies limiting the amount of money that one may lose if the market takes a downward turn and the stock price falls. Needless to say, the versatility an option offers is welcome relief from the uncertainties of traditional investing. It is noteworthy to mention, too, that options enable investors to buy a stock at a lower price, sell a stock at a higher price, or create additional income on a stock currently owned.

The most basic strategies for options employ the use of calls (which give one the right to buy a stock at a given price on a given day) and puts (which will increase in value as a stock falls). As the market moves up, down, or even sideways, it is important to use proper option strategies in different markets. For example, if the market is moving up (bullish) you will want to buy calls and sell puts. Conversely, if the market is in a downward trend (bearish), you will want to buy puts (which act akin to insurance policies). In sum, options allow you to be as conservative or as aggressive as your strategy dictates.

Five factors to consider when buying and selling options:

1. Stock Price. If the price of a stock goes up, the value of your call option will also go up (and vice versa).
2. Time. While owning a stock is essentially forever, an option is limited due to the affects of time decay. Consider the image of melting ice and use it as a metaphor for options; over time, the value of an option deteriorates. To limit the effects of time decay, always buy an option at least 90 days out and always sell your option within 30 days prior to expiration (which is the third Friday of the month).
3. Volatility. Any trader will tell you that the market is volatile, but the concept of implied volatility is often overlooked by options traders. Implied volatility is measured by a trader's expectations. There is an algorithm that looks at the options trade and, as trading accelerates, so do the expectations thus the price movement of an option increases (and vice versa). For instance, when buying an option you will see red right away; however, if you purchased the right option and exercised it properly you will see the red disappear almost instantly. Remember, when buying an option you will want to buy on the ask (the price at which sellers are willing to sell) and sell on the bid (the price potential buyers are willing to pay). Additionally, you will want to consider volume, high open interest, options spread, and, again, volatility when purchasing options. Therefore, before you trade options, it is important that you understand how volatility comes into play so that you can optimize your leveraging power.
4. Interest rates^[*]. An increase in interest rates will drive up the price of call options, and cause put premiums to decrease. To better understand the effect interest rates have on an option, consider comparing an option position to simply owning the stock outright. Because it is cheaper to buy a call option than it is to buy 100 shares of the stock, the call buyer is willing to pay more for the option when rates are relatively high (especially since they can invest the difference in the capital required between the two positions). With that, the best option analysis models include interest rates in their calculations using a risk-free interest rate (such as the U.S. Treasury rate) because interest rates are a key factor in determining whether or not you should exercise a put option early.
5. Dividends^[*]. Dividends are a critical factor to consider when determining the optimal time to exercise a stock call option. Call option buyers and sellers should always consider the impact of dividends. Whoever owns the stock as of the ex-dividend date receives the cash dividend, so owners of call options may exercise the in the money position (when the stock price is greater than the strike price) to capture the cash dividend. In other words, exercising the in the money position on the call option early would be ideal when the stock is expected to pay a cash dividend prior to the expiration date. Traditionally, the option is only exercised optimally on the day before the stock expiration date.

That said, options, like stocks, may be used to take a position in the market so as to capitalize on upward (or downward) market moves. Yet, unlike stocks, options can provide an investor the benefits of leverage over a position in an individual stock, or group of stocks, reflecting the broad market. At the same time, option buyers can also take advantage of predetermined, limited risk. Conversely, option writers assume significant risk if they do not hedge their positions. It is important to keep in mind that options are contracts that control the underlying equity needed to buy or sell the stock at a specified price and time.

In sum, options provide a variety of benefits for traders including limited risk and the ability to leverage money, as well as bring in additional income each month

Recently, investors and traders have seen a widespread correction in the market. In just one week the stock market fell nearly 800 points! Fears of credit and subprime loans sparked the correction. The good news is, however, that these market corrections are no cause for major concern. In fact, they are actually healthy for the market. Carefully, look through your stocks and you will find some great buying opportunities. When the market turns back up, so will most of the stocks in it. Remember to be patient when entering a trade, wait for the indicators to tell you the appropriate time to enter. Once you have earned a profit, protect it by selling at the first sign of technical weakness.

With that, there are several ways to sell out of a position. Before you enter a trade you should have a point when you are happy with your profits and will then sell out of the position. Another way to sell out a position is to sell half of your position, after you have hit your happy point, and hold on to the other half just in case the stock continues moving in your direction. In doing this, you have taken a decent profit. When you have made more money than your initial profit, you will then sell the other half of the position. In sum, protecting your profits is perhaps the most important decision you can make while investing.

Protecting and taking profit when you have it is perhaps the most important decision you can make while investing.

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