Options 101, Thursday, 07/20/2006
Once Upon a Time There Were Options...
by OI Staff
HAVING TROUBLE PRINTING?
The Word OPTIONS
The word options often sends a chill up and down the spines of traders everywhere. These nave traders have heard dozens of horror stories about people losing their life savings trading options. The word options generates fear. Hence, there is a huge stigma attached to the word options.
Are the horror stories true? Is it true that people have lost fortunes trading options? Of course it is. Does this still happen today? Of course it does. Will it happen again in the future? Of course it will. Why? There is one common denominator shared by those who have lost (and will continue to lose) substantial amounts trading options. They were S-T-U-P-I-D.
A rather brazen statement, you say? Possibly. But that doesnt make it any less true. These traders, (and I use the term lightly) simply dont know what they are doing. Theyre playing a game in which they dont know the rules and/or the strategies. They are out of their depth.
So, call your friends and tell them about this column. Because here is where you, and they, will learn about options. This is a no-holds-barred approach to teaching you about an incredible trading resource. What you will learn here will challenge you. What I say may anger you or make you laugh. But, you can be sure of one thing. If you have the perseverance to stick with me through the coming weeks, you will emerge with the knowledge that can turn you into a consistently profitable options trader. This is not rocket science. You and your friends have the first option read my columns or lose money.
What Is An Option?
We have to start somewhere. The beginning is as good a place as any. An option is nothing more than a tool. If you know how to use it properly, you will likely make money. If you dont, you can seriously hurt yourself.
There are two kinds of options calls and puts. First we will address the call option. Its probably best to provide you with a real life example to introduce you to the concept.
Once upon a time, Max wanted to buy a house for $100,000, but at that moment he only had $5,000. Max anticipated having the balance in three months. But, he was concerned that the price of $100,000 might go up in that period.
Heres what he did. Max approached the owner of the house and said, Ill give you $5,000 right now to take your house off the market. And I want the right to buy your house for $100,000 in three months. The owner agreed. He figured that he was going to get an extra $5,000.
Max has effectively purchased a call option on the house. Max has paid $5,000 for the right, but not the obligation, to buy the house at a specific point in time (three months) for a specific price ($100,000). So, for three months, Maxs $5,000 is allowing him to control a $100,000 asset. Thats excellent leverage and thats what many market option traders try to use to their advantage.
Back to Max.
Now, three months is a long time. Many things can happen, both good and bad. Lets look at a few different scenarios.
1. The house is inspected and Max learns that there is a serious termite problem. Plus, the house next door is sold and Max learns that Michael Jackson plans to open a child care center. Whats worse? Its a toss-up. But its not good news, is it? The value of the house is no longer $100,000. Its value is probably closer to $60,000.
So, what is Max to do? If you were paying attention, you saw that Max owns the right, but not the obligation, to buy the house. When the three months is up, or even sooner, Max can simply say, no, thanks. Ill pass to the owner. What has Max lost? Only $5,000. That was his entire risk. A loss of $5,000 is a hell-of-a-lot better than a loss of $40,000. Max has preserved his capital and can now continue his search for another real estate opportunity.
2. Max learns that oil was found in the backyard on a neighbors property. The value of the house skyrockets to $350,000 just in the hope that there is also oil on the house on which Max owns the option. Max is a happy camper. Hes looking at two alternatives. The option for which he originally paid $5,000, is now worth $250,000 (the difference between the $100,000 and the current $350,000). He has, in effect, turned $5,000 into $250,000.
Maxs other choice is to go ahead with the purchase, at the agreed upon $100,000, and hold onto the property for a further increase in value if they actually discover oil on his property. Should that happen, the house/property could be worth $1,000,000. What would you do?
Now, for a moment, Im going to jump a little ahead of ourselves to discuss Maxs two choices. If he simply sells the option, he has $250,000 in his pocket an incredible profit. If he chooses to buy the property, and pray for oil, isnt he risking the $250,000 profit? If they dont discover oil, the value of his newly purchased house is back to $100,000, maybe. Thats a gamblers mentality not a successful traders mentality thats STUPID.
Max bought a call option and had some choices thats why they call them options. Choices are always nice to have. The nicest part is that Maxs risk was defined. The $5,000 was the most Max could possibly lose of he chose not to go through with the house purchase.
Applying Call Options To The Market
Instead of buying a house, suppose you thought that IBM had a good chance of moving up in the next five months. IBM is trading at about $80. You could buy the right (but not the obligation) to buy shares of IBM stock at $80 for $5.00. Thats pretty good leverage -- $5 controlling an $80 asset.
All the same concepts apply as in our real estate example. The purchase price of $80 (known as the strike price), the specific five month period of time and the premium paid for the option ($5.00).
If IBM goes up in that period of time, great! You guessed right. Youll make a nice percentage on your $5.00 risk. If IBM goes down, you dont have to buy the stock and all you lose is the $5.00 cost of the option.
Are you ready to make your first option trade? Hell no!! Youre not even close. Keep your money in your pocket. Dont jump into the pool until you know how to swim. Theres no rush. The market will be there when youre ready. How will you know when youre ready? Ill tell you, thats how.
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Who Is This Guy?
The outspoken Mike Parnos has been writing Option Investors very successful Couch Potato Trader column for over four years. Hes been trading and teaching options for over 15 years and knows what you NEED to know to trade options profitably.
Too many traders trade the more advanced option strategies without having a good understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. And thats a recipe for disaster. If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal.
However, if youve worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.
Mike will tell you like it IS, not how you hope it will be. As you read through the columns, feel free to send him your questions.