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A Strategy You Should Consider

With the explosion of option use in recent years, you may be asking yourself, "What are options, and why would anyone consider using them?"

Options represent the right (but not the obligation) to take some sort of action -- buying or selling shares of a given stock -- by a predetermined date.

There are two types of options, calls and puts. And there are two sides to every option transaction -- the party buying the option, and the party selling (also called writing) the option. Each side comes with its own risk/reward profile, and each may be entered into for different strategic reasons.

What's a call option?
A call is the option to buy the underlying stock at a predetermined price (the strike price) by a predetermined date (the expiry). The buyer of a call has the right to buy shares at the strike price until expiry. If the call buyer decides to buy -- also known as exercising the option -- the call writer is obliged to sell his/her shares to the call buyer at the strike price.

Say an investor bought a call option on Microsoft with a strike price at $30, expiring in April. Today, that call would cost around $175 per 100 shares, or $1.75 per share. That call buyer has the right to exercise that option anytime between now and April 16, 2010, to buy Mr. Softy's shares for $30. The writer of the call would have the obligation to deliver those shares and be happy receiving $30 for them. We'll discuss the merits and motivations of each side of the trade momentarily.

What's a put option?
If a call is the right to buy, then perhaps unsurprisingly, a put is the option to sell the underlying stock at a predetermined strike price until a fixed expiration date. The put buyer has the right to sell shares at the strike price, and if he/she decides to sell, the put writer is obliged to buy at that price.

Investors with the stomach to buy Bank of America (NYSE: BAC  ) for less than $4 amid February and March's despair now sit on some sweet gains. And while they may believe that the company will continue to do well, perhaps they still harbor some gnawing concern that this recovery has been "too much, too fast." If they're concerned about the possibility of Bank of America sliding during a market pullback, they could buy a put option at the $15 strike to "protect" their gains. Buyers of the put have the right, until expiry, to sell their shares for $15. Sellers of the put have the obligation to purchase the shares for $15 (which could hurt, in the event that Bank of America shares were to decline severely).

Why use options?
Call buyers profit when the price of the underlying shares rises, since the call price will rise as the shares do. Call writers are making the opposite bet, hoping for stock price declines (or, at least, for the stock to rise less than the amount they receive for selling the call in the first place).

Put buyers profit when the underlying stock price falls, since the put price increases as the underlying stock price decreases. Conversely, put writers are hoping for the option to expire with the stock price above the strike price, or at least for the stock to decline by an amount less than what they've been paid to sell the put.

You certainly don't need options to make money in the stock market, but there are several reasons why you may want to consider using them. Calls and puts -- alone, combined with each other, or even in addition to positions in the underlying stock -- can provide various levels of leverage or protection to a portfolio.

  • Options can act as insurance to protect gains: Green Mountain Coffee Roasters (Nasdaq: GMCR  ) has more than doubled in this year, achieving a valuation some might consider "pricey." Buying a put option can lock in those gains ... minus the cost of the put.
  • Options can help investors get cheaper entry prices for their stocks. Suppose someone wanted to buy shares of Atheros Communications (Nasdaq: ATHR  ) , but was concerned about the price tag. Instead of setting a limit order, one could sell puts on the stock. If the stock reaches the strike price and the put is executed, the put writer's net purchase price would be lower by the amount they collected. If it doesn't, the put writer pockets the amount money for which the put was sold.
  • Options can be used to generate steady income from an underlying portfolio of blue-chip stocks like Costco (Nasdaq: COST  ) or Diageo (NYSE: DEO  ) .
  • Or they can be employed in an attempt to double or triple your money almost overnight. This strategy's not for the faint of heart (or perhaps strong of brain). Still, buying calls on beaten down small-caps like Innophos (Nasdaq: IPHS  ) in March 2009 would have paid off handsomely.

But no matter how options are used, it's wise to always remember Robert A. Heinlein's acronym: TANSTAAFL (There Ain't No Such Thing As A Free Lunch). Insurance costs money -- money that comes out of your potential profits. Steady income comes at the cost of limiting the prospective upside of your investment. The chance for a quick double or triple has the accompanying risk of losing the money you paid for the option.

The Foolish bottom line
Remember: Calls are the right to buy a stock, and puts are the right to sell a stock. For every buyer of an option, there's a corresponding seller. Different option users may be employing different strategies. If you're interested in using options, it's important to know how to use them appropriately in your own portfolio. To help you do just that, check out what's going on at Motley Fool Options -- just enter your email in the box below for more information.

This article was originally published on April 24, 2007 under the headline "Options: The Basics." It has been updated.

Jim Gillies owns shares of Innophos, which along with Atheros is both a Motley Fool Hidden Gems recommendation and Fool holding. Costco and Microsoft are Inside Valueselections. Costco is also a Stock Advisor pick and Fool holding. Diageo is an Income Investor selection. Green Mountain Coffee Roasters is a Rule Breakers pick. Motley Fool Options recommended a diagonal call on Microsoft. The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (5)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 05, 2009, at 12:07 PM, tkell31 wrote:

    Being relatively new to selling options they seem like good ways to increase your profits with relatively limited risk.

    I started selling options monthly and try to follow these rules

    1. Only sell options on a company you would like to own. If a put gets called you should be happy to have gotten the stock at a lower price plus you received a premium. If you feel the stock may run up in price and you will miss out then it is usually a good idea to buy some outright. I did this recently with APWR, selling some dec 12.50 put contracts at an 8% return, and buying an equal number of shares which I am happy I did.

    2. Only sell covered calls if you would be happy selling the stock at the strike price. I typically sell covered calls monthly and factor in the premium, plus the percentage difference between the current value of the stock and the strike price. Typically I'm looking for a combination of over 10%. If you are heavily invested in stable dividend stocks that pecentage will probably be closer to 5% which if fine because those stocks rarely have wild swings so you will frequently get the premium, collect your dividend, and write another cc the following month. The biggest concern with selling cc is the price will skyrocket and you will be locked out of gains. If you feel like that may happen due to some event in the near future either dont write the cc, only do it on a portion of your invesment, or write it after the event has passed. Limiting them to 30 days also reduces teh chance you will miss out on a run.

    3. When selling monthly I try not to get caught up in runs. Most stocks trade in a range, try to sell puts at the bottom and covered calls at the top. You will generate more premium and may even buy out of the postion in the same day if the volitility is significant enough. I mention this because my first month of selling options I found I had a tendency to do the opposite which I believe is just human nature.

    4. Find a broker you are comfortable with who has the lowest fees. Selling monthly and potentially daily has the drawback of generating fees.

    5. Learn what delta is and how sellers of options benefit significantly from it in the last 30 days of the options life.

    6. Dont be afraid to wait to sell. Stocks closer to the strike price generate higher premiums, some stocks mid-range barely generate any premium and while you may be tempted by having a large buffer between the stock price and the strike price you can generally waith a couple days and get a significantly better premium without significantly impacting the risk.

    7. Lower dollar value stocks generally pay larger premiums which to a large extent help offset some of the risk by lowering the basis in the stock in case the value drops.

    8. You can always buy your way out of a trade if you dont want to be involved in it any longer. This is where the delta effect is your friend usually cutting your loss to close to the value of the gain or loss of the stock.

    I really wish I understood options back in March, but better late then never I guess. I've managed an average return of 3.5% the last three months based on the premiums sold less costs and not including any stock appreciation. I'm not sure if I can continue that rate, but I'm happy to be buidling up a profit margin to offset any misses I may have.

  • Report this Comment On December 05, 2009, at 10:25 PM, pmlang37 wrote:

    "Call writers are making the opposite bet, hoping for stock price declines" -- WRONG!

    At one time, many years ago, I was very active in selling calls -- only covered calls, as selling them naked is much too risky. All of my calls were sold against stock specially bought for selling the calls, as I didn't want to mess up my regular portfolio and as the best prices were virtually almost always offered for stocks I didn't own. I quickly learned that I could get a very good return on my investment of buying the stock if it was called away from me, and that this return could be calculated in advance, so I would not sell the call if the return would be inadequate. On the other hand, if the stock's price declined, my return was less in the best case, as I now got less than the strike price for the stock when I sold it, and in the worst case would suffer a loss which could be large.

    This was in effect a financing transaction on my part, and just as a bank making a commercial loan hopes for the success of their client to get repaid in full, so I hoped for the success of the party I financed.

    So I ALWAYS hoped for the stock to rise.

  • Report this Comment On December 05, 2009, at 10:49 PM, tkell31 wrote:

    Yeah, and that was in the parenthesis you left out.

    "Call writers are making the opposite bet, hoping for stock price declines (or, at least, for the stock to rise less than the amount they receive for selling the call in the first place)."

    I agree the call writer is usually not hoping the price drops (there certainly are times when they could be, especially if they have owned the stock for some time and sold an in the money option because the premium was really tempting), but it is probably fair to say they hope it gets as close to the strike price as possible without going over, but in reality having it get called away is fine as it maximizes your profit.

    If you like to sell puts, take a look at FEED's January 5 strike price. Paying a 12%-13% premium. Granted hogs are having a tough time in China right now, but the price is finally being allowed to go up and with the next earnings report not due out until March you have a decent chance of walking away with the premium and if not the break even point is 4.40.

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