An Introduction to Options

Options are a powerful tool that all investors need to become familiar with. If
you've never used options in your portfolio, then over the course of our next
several Investor Update issues we will introduce you to the basic mechanics of
not only how options work, but also how they can work for you.

Before you get started trading options, we'd urge you to forget the stories you
may have heard about how risky they are, and how some investors have
gone bankrupt using them. The truth is that options are designed to help
investors limit and manage risk. Over the course of this multi-part series on
options we will show you how to not only make money using options, but
more importantly, how to save money as well.

THE TWO MAIN USES OF OPTIONS

Investors use options for two primary reasons -- to speculate and to hedge
their risk. All of us are familiar with the speculation side of investing. Every time
you buy a stock you are essentially speculating on the direction the stock will
move. Wall Street has coined the phrase "investing" so that buying stock does
not sound so risky, but the truth is that we are always uncertain about which
direction any equity investment is going to go. You might say that you are
positive that IBM is heading higher as you buy the stock, and indeed more
often than not you may even be right. However, if you were absolutely
positive that IBM was going to head sharply higher, then you would invest
everything you had into buying the stock. All rational investors realize that
there is no "sure thing" when it comes to investing, as every investment incurs
at least some risk. This risk is what the investor is compensated for when he or
she purchases an asset. When you purchase options as a means to speculate
on future stock price movements, you are limiting your downside risk, yet your
upside earnings potential is unlimited (we'll explain this in more detail later).

Aside from speculation, investors also use options for hedging purposes. A
hedge is not just a little green bush in your front yard, it is a way to protect
your portfolio from disaster. Hedging is like buying insurance -- you buy it as a
means of protection against unforeseen events, but you hope you never
have to use it. The fact that you hold insurance helps you sleep better at
night. Consider this -- almost everyone buys homeowner's insurance, right? But
why exactly do they do this? Since the odds of having your house destroyed
are relatively small, this may seem like a foolish investment to make. After all,
most of us will never have a fire, flood or any other hazard that would cause
us to cash in on our insurance. However, we all continue to pay our insurance
premiums every year. Why do we go on paying these hefty fees year after
year instead spending the money on something we would perhaps enjoy
more? The answer to this question is obvious -- our homes are very valuable to
us and we would be devastated by their loss. Because of this fear of loss, most
of us will happily pay someone else every year to bear this risk for us, no
matter how remote the chances of loss might be. If you employ certain
options strategies as a means to hedge your portfolio, you are essentially
doing the same thing -- paying someone to protect you from unforeseen risks.
(We'll teach you how to do exactly that over the course of this multi-part
options trading series.)

OPTIONS CHARACTERISTICS

Options are derivative instruments, meaning that their prices are derived from
the price of another security. More specifically, options prices are derived
from the price of an underlying stock. This will all become very clear shortly.

Another important thing to understand is that every option represents a

contract between a buyer and seller. The seller (writer) has the obligation to
either buy or sell stock (depending on what type of option he or she sold --
either a call option or a put option) to the buyer at a specified price by a
specified date. Meanwhile, the buyer of an options contract has the right, but
not the obligation, to complete the transaction by a specified date. When an
option expires, if it is not in the buyer's best interest to exercise the option, then
he or she is not obligated to do anything. The buyer has purchased the option
to carry out a certain transaction in the future -- hence the name.

Here are a few terms you must first become familiar with before trading
options:

• Option Buyer (Option Holder) -- Party that purchases and holds the
options contract.
• Option Seller -- Party that writes, or creates, the options contract.
• Strike Price -- The price at which the option seller agrees to buy or sell a
certain stock in the future.
• Expiration Month -- The month in which the option will expire.
• Expiration Date -- This is always the third Friday of the month in which
the option is scheduled to expire.
• Option Contract -- Each options contract represents an interest in 100
shares of a certain underlying stock.
• Put Option -- This type of option gives the option holder the right, but
not the obligation, to sell 100 shares of a particular underlying stock at
a specified price (the strike price) on a specified date (the expiration
date). For example, let's say you were to purchase a put option on
shares of Microsoft (MSFT) with a strike price of $50 and an expiration
date of March 19th. This option would give you the right to sell 100
shares of Microsoft at a price of $50 on March 19th (the right to do this,
of course, will only be valuable if Microsoft is trading below $50 per
share at that point in time).
• Call Option -- This type of option gives the option holder the right, but
not the obligation, to purchase 100 shares of a particular underlying
stock at a specified strike price on the option's expiration date. For
example, let's say you were to purchase a call option on shares of Intel
(INTC) with a strike price of $40 and an expiration date of April 16th. This
option would give you the right to purchase 100 shares of Intel at a
price of $40 on April 16th (the right to do this, of course, will only be
valuable if Intel is trading above $40 per share at that point in time).
• "In-The-Money" Option -- An option that, if it were exercised today,
would be worth more than $0. In the case of a call option, the option is
 only considered to be "in-the-money" when the price of the underlying
stock is greater than the option's strike price. So, in the case of our Intel
example above, the call option will be "in-the-money" when shares of
Intel are trading above $40. Meanwhile, in the case of a put option,
the option is only considered to be "in-the-money" when the price of
the underlying stock is less than the option's strike price. So, in the case
of our Microsoft example, the put option will be "in-the-money" only
when shares of Microsoft are trading below $50 per share.
• "Out-Of-The-Money" Option -- An option that, if it were exercised
today, would not be worth a single cent. In the case of a call option,
the option is considered to be "out-of-the-money" when the price of
the underlying stock is less than the option's strike price. So, in the case
of our Intel example above, the call option will be " out-of-the-money "
when Intel is trading below $40 per share. After all, if Intel is trading for
less than $40 (let's say it is at $35), then the right to purchase Intel at a
price of $40 per share is completely worthless (if you can buy the stock
in the open market for $35, then you certainly wouldn't want to buy it
for $40). Options traders use the term "out-of-the-money" to describe
this type of situation. The analysis is similar when it comes to put options.
In the case of a put option, the option is considered to be "out-of-the-
money" when the price of the underlying stock is greater than the
option's strike price. So, in the case of our Microsoft example, the put
option will be "out-of-the-money" when shares of Microsoft are trading
above $50 per share.
• "At-The-Money" Option -- An option is considered to be "at-the-money"
when its strike price is exactly equivalent to the price of the underlying
stock.

EXAMPLE: CALL OPTION CONTRACT

As a quick example, let's say IBM stock is currently trading at $100 per share.
Now let's say an investor purchases one call option contract on IBM at a price
of $2.00 per contract. Note: Because each options contract represents an
interest in 100 underlying shares of stock, the actual cost of this option will be
$200 (100 shares x $2.00 = $200).

Here's what will happen to the value of this call option under a variety of
different scenarios:

• When the option expires IBM is trading at $105.

Remember: The call option gives the buyer the right to purchase shares of
IBM at $100 per share. In this scenario, the buyer could use the option to
purchase those shares at $100, then immediately sell those same shares in
the open market for $105. Because of this, the option will sell for $5.00 on
the expiration date (since each option represents an interest in 100
underlying shares, this will amount to a total sale price of $500). Since the
investor purchased this option for $200, the net profit to the buyer from this
trade will be $300.

• When the option expires IBM is trading at $101.

 Using the same analysis as shown above, the call option will now be worth
$1 (or $100 total). Since the investor spent $200 to purchase the option in
the first place, he or she will show a net loss on this trade of $1.00 (or $100
total).

• When the option expires IBM is trading at or below $100.

If IBM ends up at or below $100 on the option's expiration date, then

contract will expire out-of-the-money. It will now be worthless, so the
option buyer will lose 100% of his or her money (in this case, the full $200
that he or she spent for the option).

The Five Basic Components of Options Pricing

After you have decided whether you are hedging or speculating with your
options purchase (please see Lesson #1 for further details on this topic), you
will then need to determine which specific options fit your needs. When
looking up an options quote -- more commonly referred to as an options
chain -- you will notice that there are a barrage of choices available to you.
Simply knowing that you wish to hedge or speculate is not sufficient. You will
need to determine if your desired strategy requires you to trade a put or a call
option, how long you wish the expiration date to be, and what strike price
you would like to trade. Before trading options, it is important to familiarize
yourself with the factors that impact options prices so you choose the best
one to meet your needs.

Factors that determine option pricing:

Option pricing is determined using a complex differential equation

formulated by Myron Scholes and Fischer Black in 1973. In 1997 these two
professors were awarded the Nobel Prize for their efforts. The Black-Scholes
formula in detail and its explanation are beyond the scope of this article.
Fortunately, however, it is not necessary to understand the model’s intricacies
in order to make proper option trades.

The five basic components of option pricing include the following:

• Underlying Asset Price -- The price of the underlying stock or index the
option is written on.
• Asset Volatility -- Amount of uncertainty associated with the asset’s
expected return. In general, the higher the volatility the more
expensive the option will be. For example, if an asset’s value is $100
today, and next month the price is estimated to be either $125 or $75,
then the amount of uncertainty here is very high. Because of this, the
option price will be high as well (after all, the more volatile the security,
the greater chance that it will deliver large returns for the option
holder). This uncertainty of return is one of the main drivers of option
prices.
• Time to Expiration -- The amount of time left before the option expires.
The price of an option decreases as it approaches its expiration date.
 Why is this the case? Well, as the expiration date approaches, the
chances of the option gaining in value become lower and lower
because the underlying security has less time in which to make a major
up or down move.
• Risk-free rate -- For a variety of reasons that are beyond the scope of
this article, the rate of return that may be earned without bearing any
risk also comes into play when pricing options. Normally this is assumed
to be the rate of interest earned by U.S. Treasury Bills.
• Option Strike Price -- This is the price at which the option can be
exercised.

All of these factors play an important role in determining every option’s price.
The only two factors that an investor has any control over, however, are time
to expiration and the strike price (this is assuming, of course, that you've
already chosen the security on which you're going to trade the option).
Because of this, investors should concentrate their efforts on choosing the
appropriate strike and expiration that best suits their needs. The following are
rules of thumb for what hedgers and speculators should consider:

Hedging:

• Use Puts -- Investors are generally long the market. In other words, they
generally own stocks but do not short them. To offset the risk of owning
a large stock portfolio (or large individual stock position), you can buy
put options that will increase as your portfolio (or individual stock)
declines. By purchasing put options, investors can limit the amount of
money they will lose if the market plummets.
• Longer Expiration -- Investors normally hold stocks for longer periods
than speculators and therefore buy insurance for longer periods of
time. They tend to purchase options with longer expiration dates.
• Out-of-the-Money Options -- Most investors are concerned with buying
insurance to protect their capital from falling below a certain amount.
This amount is generally somewhere below where the current stock
price is.

Speculating:

• Use Calls -- Speculators usually purchase options on a particular stock

rather than the actual stock itself. Why? Well, if the speculator is correct
in predicting the direction of the stock, then he or she will make far
more money by holding options thanks to the leverage that options
provide. An investor can control a large amount of stock with a very
small amount of money by utilizing options.
• Short Expiration -- Speculators usually expect a move in a stock in a
short amount of time. Therefore, they often buy less expensive options
with short expiration dates.
• In-the-Money Options -- Many different trading strategies existing, but
in general, speculators often buy in-the-money options so they can
capture profits more quickly from rising stock prices.
There are a number of risk/reward characteristics of in- or out-of-the-money
(ITM/OTM) options that all investors should consider. An ITM option will cost
significantly more money to purchase, but the probability that it will at least
have some value at expiration will be far greater. An OTM option will cost less
money up front, but the probability of it expiring worthless will be much higher.
The reason investors purchase OTM options is due to the fact that a correct
bet can lead to very significant gains of many times your purchase price.
Meanwhile, the potential downside from such a purchase is usually a total
loss.

Sometimes it can help to visualize what happens when a trade is made. The
diagram below illustrates an example of what a sample option will be worth,
as well as the gain/loss to the investor who made it. Once again, we will use
shares of IBM as an example.

Let's suppose it is January and the stock is currently trading at exactly $100
per share. An investor who owned 100 shares of IBM and wanted to hedge
against a loss until the 3rd Friday in February would likely purchase a February
100 put option contract on IBM. This means that the buyer of the put would
essentially be insured against a loss below $100, less the cost of the option. In
this example, we will assume the option cost is $3. This means that no matter
what happens, the investor’s position in IBM will not be worth less than $97
($100 - $3 option cost) by expiration in February.

In this example, we can see that the put option increases in value as the stock
price declines below $100. If IBM is trading above $100 per share on the third
Friday in February (the expiration date in this example), then the option will
expire worthless and the investor will lose his or her entire option premium. But
since the investor in this example actually owns IBM shares, this will likely be of
little consequence.

However, if IBM tumbles to $90 at expiration, then the investor will have lost
$10 on the stock. Thankfully though, this investor decided to hedge his/her
position by purchasing a put option. And since put options rise in price as the
underlying security falls, this particular option will have soared in value. It will
now be worth $10. Subtract the cost of the option, $3, and we can see that
the investor's net position will be worth exactly $97. It's important to note that
the value of the investor's position will remain $97 even if the price of IBM
drops to zero! So, as you can see, purchasing put options against stocks that
you own in your portfolio will require you to pay option premiums, but it will
also protect you from suffering catastrophic losses if the market nosedives.

This strategy is especially useful if you're looking to lock in gains after a stock
has experienced a significant run-up. You may still believe the stock will
appreciate more, but you might also be unwilling to let it decline below a
certain point.

Sticking to our same example above, consider what would happen if IBM had
just skyrocketed to $100 in a brief amount of time (before the investor
purchases the put option). In this case, the investor might be tempted to exit
the position to lock in his/her gains. Although the investor could sell the stock
immediately at $100, he/she could also use the option strategy above
(purchasing a FEB 100 put option) to limit any potential future losses to just $97.
If the stock were to subsequently appreciate to $120, then the investor who
sold his/her shares would not participate in the additional $20 gain. However,
if the investor utilized the put option purchase, then he/she would have
enjoyed the safety of locking in a minimum stock price (in this case $97), while
still being able to participate in further gains. So, if IBM soared further, jumping
from $100 to $120, then the investor's net position would still be worth $117
($120 for the stock minus $3 to purchase the option). That's a small sacrifice to
make for securing a gain!

Selling Options

Selling options is another aspect of trading that investors should become

familiar with. Up to this point we have only discussed the purchase side of
options. Sometimes, however, it is in the investor’s best interest to sell, or write,
options. When you write options, you'll have a very different set of
risks/rewards versus purchasing them. But before we delve into that topic, let's
first take a look at the two forms of options writing:

· Covered -- The writer of the option owns the underlying stock or asset.
· Naked -- The writer of the option does not own the underlying stock. In this
instance the writer is most likely speculating on the direction the stock will
move and not hedging a position.

The safest way to sell an option is to write what is known as a "covered call".
This strategy is so safe, in fact, that it is suitable for most retirement (IRA)
accounts. In this type of trade, the investor sells a call option on an underlying
stock that he/she already owns. This trade is usually made in an effort to
generate additional income from a particular holding.
Here is how the process works:

Assume that in January an investor owns 100 shares of IBM stock, which
currently trades at $100. Over the course of the next month, the investor does
not believe that IBM will trade for more than $105. With this expectation, the
investor would be wise to sell an option contract on IBM for $105 to another
investor who feels differently. Suppose that an IBM FEB 105 option sells for $3.
The investor who writes the option will therefore receive $3 today (or $300
total, since each option represents an interest in 100 underlying shares) in
exchange for selling the option (even though the option does not expire until
next month).

Now consider the following scenarios:

IBM trades at $110 at expiration. In this scenario, the writer was too
conservative in his estimate of where IBM would trade this month. The writer
will therefore be obligated to sell 100 shares to the buyer of the call option for
$105 each. The net impact to the options seller is $105 (for selling the stock) +
$3 (for selling the option) to yield $108. This will be the net result for the seller
no matter how high IBM's shares soar. So, as you can see, by selling a covered
call, the option writer has limited his/her upside potential. In return, he/she
received $300 for the sale of the option contract.

IBM trades at $103 at expiration. In this scenario, the writer was accurate in
his/her estimate. The writer is not obligated to sell his/her shares because the
buyer would not want to buy them at $105 (after all, the buyer could instead
purchase them in the open market for just $103). The net result is that the
investor generates $300 in additional income while still keeping his/her stock,
which also gained $300 during the month.

IBM trades at $95 at expiration. In this scenario, the investor overestimated the
return on the stock. Although the investor will have suffered a $5 loss in his/her
stock holdings, this loss will be buffered by the $3 premium received for writing
the call. The investor will still hold his/her shares, and will have lost just $200 in
total (versus $500 if he/she hadn't sold the call option).
The covered call strategy works best when the investor plans on holding the
underlying stock for a long period but does not expect a significant increase
in the near term. As you can see from the diagram above, the investor is
limiting his/her upside potential to $8 in return for a guaranteed $3 premium. If
shares of IBM tank, then the investor's losses can still be significant. However, if
the stock declines, then thanks to the options sale the investor will always be
$3 better off than if he/she had merely held the stock alone. (Please note that
you can also employ a similar strategy by shorting a stock and selling a put
against the position. This is referred to as writing a covered put.)

Naked Option Writing

When an investor writes an option on a stock he/she does not own, it is

referred to as writing a “naked” options contract. This strategy is mainly used
for speculating. The investor must be very confident about the direction the
stock will go and have the resources available to cover any mistakes.

For obvious reasons, naked option writing is only available to experienced or

expert traders. This is because the investor is taking on a possibly unlimited
amount of risk in exchange for a fixed premium. Why is the potential risk
unlimited when it comes to selling naked options? Well, in the example
above, the investor already owned IBM stock, so even if IBM rapidly
appreciated (the worst-case scenario), the investor could simply sell his/her
stock for a lower-than-market price. However, if the investor had written a
naked call option (in other words, he/she did not own IBM and still sold this
call option), then the result could have been devastating.

Suppose that IBM developed a revolutionary technology and the stock price
doubled in a short period of time to $200 (not a likely scenario, but it can
happen nonetheless). The investor who sold the option for $3 would now have
to sell IBM stock to the option purchaser for the agreed upon price of $105.
However, the market price of IBM stock is now $200. In order to deliver the
stock to the option buyer, the option writer must purchase IBM in the open
market for $200, then sell those same shares immediately to the option buyer
for $105. If you factor in the $3 that the option writer initially received for selling
the contract, then his/her total losses would be a whopping $92 per contract
in this case.

Note: To offset this risk of dramatic losses, some investors will sell an option with
a lower strike price and simultaneously purchase an option with a higher strike
price. This technique lowers the return the investor receives, but it also limits
the losses that he/she might incur.

Conclusion
There are many instances in which you might find selling options appropriate.
If you are determined to hold on to a particular stock for the long haul, then
we suggest look into the process of writing covered calls. This technique will
help you add real income to your portfolio and compliment your holdings. If
you plan to hold a stock for the long haul anyway, then the worst that can
happen is you might be forced to sell your stock at the end of the month (but
for a price you would gladly have accepted at the beginning of the month).
You should note that in the long run, since options tend to lose their value as
they approach their expiration date, options sales tend to be much more
profitable than options purchases. If you decide to sell options naked, then
please use extreme caution and be cognizant of losses you might face. This
strategy may work 9 out of 10 times, but you better be prepared for the one
time it may dramatically go against you.

Portfolio Hedging

Many times it is in an investor’s best interest to lock in recent gains or to

protect a portfolio of stocks from a decline beyond a certain price. One way
to do this would be to purchase a put option contract on each of your
various holdings (this would essentially allow you to "lock in" a particular sale
price on each stock, so even if the market crashed, your overall portfolio
wouldn't suffer much). However, if you hold a large, diversified portfolio of
stocks, then it is probably not cost-effective to insure each and every position
in this manner.

As an alternative, you might want to consider using index options to hedge

the risk in your portfolio. Index options are options not on an individual stock,
but rather on an entire index. Many different indices have options available,
including the Nasdaq 100, the Dow Jones Industrial Average and the S&P 500.
For the purposes of today's example we will use the S&P 500-- ticker symbol
"SPX"--as a proxy for the overall market's return. With some careful planning,
you should be able to offset a sharp decline in your portfolio by hedging your
overall position with index options. Though it is impossible to forecast exactly
how your portfolio will perform during a steep market sell-off, you can
calculate this out fairly close to the actual result.

Before you can hedge your portfolio against a major market correction,
however, you'll need to figure out two key items. First, you'll need to determine
which particular index to use as a proxy for your portfolio. If you hold primarily
high-tech stocks (or if you just want to hedge against a downfall in your
technology holdings), then you might want to consider trading options on the
Nasdaq 100. Alternatively, if your portfolio consists mainly of blue-chip
companies, then you might want to use the Dow Jones Industrial Average.
Again, since we're going to assume that your portfolio consists of a well-
diversified mix of different stocks, for the purposes of today's example we'll use
the S&P 500 as our proxy.

Next, you'll need to find the correct number of options to use as a portfolio
hedge. Along those lines, here are a few important items to consider:

-- You first need to derive an estimate of beta (ß). This may sound like an
obscure technical term, but beta simply measures the amount of variance in
a portfolio in relation to the market. If you were using the S&P 500 as a proxy
for the market, then ß would indicate how much your portfolio moves when
the S&P 500 changes by 1%. For example, if you notice that, in general, your
portfolio changes by 2% whenever the S&P moves up 1%, then your portfolio
has a ß of 2.0. If the portfolio changes by 0.5%, then ß = 0.5. If the portfolio
changes by 1%, then ß = 1.0. (Beta is an important component of all options,
so it would be a useful exercise to try this with your portfolio or individual stocks
to become more comfortable with this term.)

-- The next step is finding the risk-free rate. As the name implies, this is the rate
of interest that can be obtained without incurring any risk. For the short-term,
we usually use the appropriate three-month T-bill rate.

-- If your portfolio pays any dividends, then you need to formulate the
portfolio’s dividend yield. This can be found by adding the amount of
dividends paid during the year and dividing that figure by the value of your
portfolio. For example, if you receive roughly $40,000 in dividends per year on
a $1 million portfolio, then your portfolio's dividend yield is 4% (40,000 ÷
1,000,000).

Now consider the following example:

Suppose you own a $1 million portfolio of stocks and you wish to insure this
portfolio against a decline of greater than -6% during the next three months.
In other words, you want to put a hedge in place to make certain that your
portfolio does not fall below $940,000. To make the calculations fairly simple,
let's assume that the S&P 500 index is currently trading at 1000. Let's also
assume that your portfolio is volatile and generally doubles the S&P 500’s
gains or losses. Therefore, the ß is 2.0. Finally, let's assume that the risk-free rate
is 4% and the dividend yields on both your portfolio and the S&P 500 are also
4%. The assumed return of the SPX is 12% per year. (We should note that it is
not necessary to have an accurate forecast of the market's return for this
hedge to work correctly.) In this example, if you want to employ SPX put
options as a hedging tool, then here's how to calculate how many contracts
you need to purchase:

Total Return of SPX in Three Months:

n three month’s time you expect a 3% return (assuming a 12% annual rate)
and a 1% dividend (assuming a 4% annual yield) for a total return of 4%.

Excess Return of SPX:

he excess return of any asset is the amount it returns over the risk-free rate. In
this case, the risk-free rate would be 1% (assuming a 4% annual rate) in three
months. The excess return is therefore 3% (4% total return – 1% risk-free).

Total Return of Portfolio in Three months:

For this example we stated that the ß of the portfolio is 2, which implies that if
the market returns 3%, then your portfolio will double that amount by returning
6%. The expected dividend is still 1% during the next three months, so the total
expected return will be 7%.

Excess Return of Portfolio:

The expected excess return is 7% and the risk-free rate is 1%, so the excess
return here will be 6%. This is the return you expect in three month’s time.

The table below illustrates how the portfolio is expected to behave in relation
to the market:

Value of S&P 500 Index Value of Portfolio

in Three Months in Three Months
1060 $1,120,000
1030 1,060,000
1000 1,000,000
970 940,000
940 880,000

From this chart we can see that the portfolio will perform twice as well, or
twice as poorly, as the market. In this example, you do not want to let your
portfolio fall below $940,000 in the next three months. Using the table, you can
see that buying SPX puts with a strike price of 970 will accomplish this. To find
the optimal number of put option contracts to purchase, use this formula:

Portfolio Value ÷ [(100 x Current Strike Price) ÷ ß] = number of put contracts

In this example, where the portfolio value equals $1,000,000 and the current
strike price is 1000, the calculation would be as follows:

$1,000,000 ÷ [(100,000) ÷ 2] = $1,000,000 ÷ 50,000 = 20 put contracts

This means you should buy 20 SPX 970 Put contracts that expire in three
months to insure your portfolio against a decline below $940,000.

To see that this is correct, suppose the SPX finishes at 940 when the options
expire in three months. This implies from the chart that your portfolio would be
worth just $880,000. However, the SPX 970 Put contract will expire "in the
money" and will be worth $30 (970 – 940) at expiration. In this scenario, your 20
options contracts (each contract is for 100 options) will now carry a value of
$60,000. When you add that figure to the $880,000 that your portfolio is now
worth, this equals exactly $940,000. You can perform this procedure for any
decline in the SPX, and in every case you will find that your overall portfolio
will still be worth a minimum of $940,000 at expiration.

Conclusion
Portfolio hedging is an important technique to learn. Although the calculation
of ß must be correct to ensure an exact result, most investors find that even a
reasonable approximation will deliver a satisfactory hedge. This technique is
especially helpful when an investor has experienced an extended period of
gains and feels this increase might not be sustainable in the future. Like all
option strategies, portfolio hedging requires a little planning before executing
a trade. However, the security that this strategy provides could make it well
worth the time and effort in a period of declining stock prices
 Spread & Combination Trades

A virtually limitless number of options trading strategies are available to

investors. In today's installment of our series on options trading my staff and I
will discuss two more advanced strategies--the spread trade and the
combination trade. Both of these trades involve taking two option positions
on the same stock.

Spread Trades

In a previous options lesson we discussed the process of writing a covered

call. As you may remember, this involves selling an option on a stock that you
currently hold in your portfolio. A spread is very similar to a covered call,
except it basically involves covering an option instead of the underlying
stock. An investor should utilize this particular strategy if he/she feels that a
stock will move in one direction but believes the gains will be limited.

To execute a spread trade, the investor must buy an option at one strike
price, then sell an option at a strike price that is farther out-of-the-money
(both contracts should expire in the same month). Since this type of trade
involves the sale of an option, the trader will receive initial income from this
transaction. The income received will not be enough to offset the cost of
buying the first option, but it will lower the overall cost of the trade. However,
in exchange for this lower transaction cost, the investor will essentially forfeit
any gains that he/she would have earned above a certain set level.

To gain a better understanding of how a spread trade works, let's take a look
at an example...

Let's suppose shares of IBM are trading at $100 and the trader in our example
has no current position in the stock. By the time of option expiration the trader
feels that IBM will likely trade above $105, but will not climb higher than $110.
Let's assume that the price of an IBM 105 call option is $3. Meanwhile, the IBM
110 calls are selling for $1. To maximize the profit potential from this type of
scenario, the investor would probably decide to purchase a spread. To do
this, he or she would buy the IBM 105 call for $3 and at the same time sell the
IBM 110 call for $1. The net result of these two transactions would be a debit
to the trader of $2 ($3 paid to purchase one option - $1 received for the sale
of the other option).

As shown in the diagram below, this strategy lowers the amount that the
trader has at risk in the trade ($2 in this example), but it also limits his/her
upside potential (to $3 in this case). In this particular example the market is
not predicting a great deal of volatility in IBM, as reflected by the low option
costs.
There are a variety of different ways to use spreads when trading. Another
commonly used spread is called a calendar spread. In this type of spread, an
investor believes that a particular stock will move to a certain price, but will
not do so during the current period of time. With this in mind, to execute a
calendar spread the investor would buy an option (usually out-of-the-money)
with an expiration date later in the year and would simultaneously sell an
option that is set to expire closer to the present time. The desired result is for
the option sold with the closer expiration date to expire worthless, yet for the
stock to come close to its strike price. The investor would then keep the option
premium earned on this sale and would use the proceeds to offset the cost of
purchasing the other option.

Combination Trades

A combination is an option strategy where the trader takes a position in both

call and put options in the same underlying stock. For the sake of example, in
this section we will look at a very popular trade called a long straddle. In this
particular type of trade, an investor will purchase both a call and put on the
same stock, and both of these options will have identical strike prices and
expiration dates.

It may initially sound counterintuitive to be on both the long and short side of
the same stock. After all, if you're only trading regular common stocks, it
doesn't make sense to be both long and short at the same time. In the
wonderful world of options, however, it is sometimes beneficial to enter into
this type of trade. Straddles are designed to allow investors to profit from a
large move in a given stock. The beautiful thing about them is that the actual
direction the stock takes does not matter, the only thing that matters is
whether the stock makes a substantial move. This is the key point to trading
straddles. An investor does not have to be certain which direction the stock
will move; just certain it will move strongly one way or the other. Because of
this, straddles make an excellent choice in choppy markets where the only
certainty is high volatility.

Let’s take a look at an example of how a straddle trade works...

Once again, let's assume that IBM is currently trading at $100 per share. Due
to a significant event that will occur this month (an expected news event,
earnings release, etc.), an investor might believe that the stock will move at
least 10% in either direction. In this example, let's assume that both the IBM 100
put options and IBM 100 call options are trading at $3 each. To take
advantage of this the investor would enter into a straddle trade by
purchasing both the IBM 100 put for $3 and the IBM 100 call for $3 (for a total
of $6 out of pocket).

As you can clearly see in the payoff diagram of this trade above, this
particular straddle will be profitable if the price of the stock moves more than
$6 in either direction by the time the options expire. If the price remains at
exactly $100, then the investor will suffer a maximum loss of $6. Once the price
of IBM's underlying shares moves beyond $94 or $106 the investor will begin to
realize a profit from the trade. If the price does indeed move at least 10%, as
the investor predicted, to either $90 or $110, then the profit will be $4 ($10 sale
of option - $3 purchase of call - $3 purchase of put).

Both spreads and straddles are designed to limit an investor’s losses yet still
allow him/her to realize significant gains. By using multiple option positions at
the same time, you can create powerful tools to help you earn greater returns
as well as manage risk in your portfolio. With some planning and a little
practice you can use the same techniques that professional traders employ
to earn above-average profits.
 Collar & Butterfly Trades

There are two final strategies that options investors should be aware of: collars
and butterflies. Although these two are not as widely used as the other
strategies we've detailed previously (please see lessons #1-5 for details), they
can often prove very useful when the situation is right.

Collar
A collar is an interesting strategy that is often employed by major investment
banks and corporate executives. This position is made by selling a call option
at one strike price and using the proceeds to purchase a put option at a
lower price. The cost to the investor to make this trade, therefore, is essentially
zero.

Investors who hold a large position in an underlying stock and wish to

liquidate their holdings at some time in the future commonly use this type of
trade. Why? Well, the collar allows them to lock in a particular sale price (in
actuality, it ends up being a range between two prices) ahead of time. In
other words, after implementing the collar trade, they then know the exact
highest and lowest dollar amounts they could potentially receive when they
sell their underlying stock. Speculators do not commonly make this type of
trade since it is a high-risk, low-reward scenario unless you hold the underlying
stock. However, if the investor already owns the underlying stock, then the
trade is very low-risk and low-cost.

Example:
Judy is an executive at IBM and has recently been awarded a significant
amount of IBM stock, which is currently trading at $100. She feels strongly
about IBM’s prospects over the next three months, but she remembers that
many other people who worked at high-tech firms had the same belief in the
1990s when the Internet bubble collapsed. Most of these people lost virtually
all of their investment. In this particular case, however, Judy cannot afford to
lose her entire investment. On the other hand, she would also like to try to get
$10 more for per share her stock, or $110.

After assessing her personal financial situation, Judy determines that she
cannot afford to sell her shares for anything less than $90. To hedge her
current holdings, she decides to institute a collar trade. (This trade gets its
name because the position is essentially "collared" between two prices.) It is
currently January, and to collar this position for three months she sells one IBM
MAR 120 call for every 100 shares she owns. With the amount she receives
from this sale she simultaneously buys one IBM MAR 80 put for every 100 shares
that she owns (we will assume that both sides cost $5 each). Since both of
these options cost the same price, the net cost of this initial trade was $0 to
her. With this trade, Judy now knows that no matter what happens, she will
receive an amount between $90 and $110 if she decides to sell her IBM shares
when the options expire in March.
As the graph above illustrates, Judy's total profit or loss from the combinations
of these positions is limited to $10. This means that if IBM rockets up to $200,
the most Judy will receive is $110. Conversely, if IBM crashes to $20, the least
she will receive is $90. For an investor who is comfortable with either of the two
scenarios, this is an excellent hedging strategy.

Butterfly
Traders often use the butterfly strategy when they feel a particular stock will
remain neutral during a certain period. By entering into a butterfly trade, the
trader is essentially betting that the underlying stock price will remain close to
where it is currently. This trade requires three separate positions (four total
contracts), and is therefore a bit more complex than the collar. It can be
made using either put options or call options. For simplicity, we will use calls in
this example. To execute this trade, the investor will need to buy two calls --
one at a low strike price and one at a higher strike price. The investor also
needs to sell two options with strike prices at or near the current price. In the
end, this type of trade will pay the maximum amount if the stock finishes at
the middle strike price. The trade has very limited downside risk, but the trader
must estimate the correct future stock price to a fairly narrow range in order
to make the trade profitable.

Example:
An investor believes that IBM, which is once again trading at $100, will remain
relatively unchanged during the next month. To take advantage of this, but
also desiring to limit downside risk, the trader sets up a butterfly trade. To do
this, the trader buys one IBM 95 call for $6 and one IBM 105 call for $1. The
trader will also sell two IBM 100 calls for $3 each. The net result of all of these
positions will be a cost of just $1 to the trader, as shown below:

Option Trade Cost

Sell 2 IBM 100 calls +$6
Buy 1 IBM 95 call -$6
Buy 1 IBM 105 call -$1
Total -$1

A butterfly trade may seem complicated at first glance due to the large
number of options positions required to construct it. However, a quick look at
the diagram above should make the payoff relatively easy to understand. In
this example, the trader obtains the maximum payoff when the stock finishes
at $100. As IBM's price moves further and further from $100 in either direction,
the trade begins to lose value. When the price reaches (or moves beyond)
$95 or $105, the trade then leads to a maximum loss of $1. This diagram
clearly shows just how accurate the trader must be at forecasting IBM's future
stock price in order to reap a profit from the trade. If the outcome does not
go according to plan, however, then the worst that can happen is the trader
loses $1, no matter how high or low the price goes.

Conclusion
The two options strategies outlined above -- the collar and the butterfly --
should only be used in very specific situations. However, when used
effectively, they can be extremely profitable. A collar can help lower your
volatility during an uncertain time period and can help you lock in a range of
sale prices for a stock you currently own. Meanwhile, the butterfly is a good
strategy for periods where a stock is not likely to fluctuate to a great degree.
The butterfly trade can change what would normally be an unprofitable
trading period for the stock into a profitable one.

Intrinsic Value vs. Time Value

In this final installment of our options series we'll cover two very important
topics--intrinsic and time value. These two concepts are what comprise an
option’s price. By being familiar with these terms and knowing how to use
them, you'll find yourself in a much better position to choose the option
contract that best suits your particular investment needs.

Intrinsic Value -- This is the value that any given option would have if it were
exercised today. It is defined as the difference between the option's strike
price (X) and the stock's actual current price (CP). In the case of a call
option, you can calculate this intrinsic value by taking CP - X. If the result is
greater than zero (in other words, if the stock's current price is greater than
the option's strike price), then the amount left over after subtracting CP - X is
the option's intrinsic value. If the strike price is greater than the current stock
price, then the intrinsic value of the option is zero--it would not be worth
anything if it were to be exercised today (please note that an option's intrinsic
value can never be below zero). To determine the intrinsic value of a put
option, simply reverse the calculation to X – CP.

To illustrate, let's say IBM stock is priced at $105. In this case, an IBM 100 call
option would have an intrinsic value of $5 ($105 - $100 = $5). However, an IBM
100 put option would have an intrinsic value of zero ($100 - $105 = -$5 --->
since this figure is less than zero, the intrinsic value is zero. Again, intrinsic value
can never be negative.). On the other hand, if we were to look at an IBM put
option with a strike price of 120, then this particular option would have an
intrinsic of $15 ($120 - $105 = $15).

Time Value -- This is the second component of an option’s price. It is defined

as any value of an option other than its intrinsic value. Looking at the example
above, if IBM is trading at $105 and the IBM 100 call option is trading at $7,
then we would say that this option has $2 of time value ($7 option price - $5
intrinsic value = $2 time value). Options that have zero intrinsic value are
comprised entirely of time value. Time value is basically the risk premium that
the seller requires to provide the option buyer with the right to buy/sell the
stock up to the expiration date. Think of this component as the “insurance
premium” of the option.

Time value is easy to see when looking at the price of an option, but the
actual derivation of time value is based on a fairly complex equation.
Basically, an option's time value is largely determined by the amount of
volatility that the market believes the stock will exhibit before expiration. If the
market does not expect the stock to move much, then the option's time
value will be relatively low. Meanwhile, the opposite is true for stocks that are
expected to be very volatile. For example, if IBM stock is priced at $100 and
the IBM 100 call is priced at $5, then the market is expecting at least a 5% ($5
/ $100) upside move prior to expiration. High-beta stocks, or those that tend to
be more volatile than the general market, usually have very high time values
because of the uncertainty of the stock price prior to an option's expiration.

Conceptually, this all makes perfect sense. After all, if you are an options
seller, then you will probably be willing to sell options at very low prices on
shares of, let's say, a slow-moving utility stock like Southern Company (SO). On
the other hand, if you were to sell options on shares of a highly volatile stock
like Amazon.com (AMZN), then you would require much greater
compensation. After all, Amazon's stock has a much greater chance of
moving quickly in one direction or the other, which could end up costing you
a great deal of money if the stock moves in a favorable direction for the
option buyer.

Another important thing to understand about time value is that it decreases

as an option gets closer and closer to expiration. Why is this the case? Well,
the easiest way to think about this is that as the option approaches expiration,
the underlying stock has less and less time to move in a favorable direction for
the option buyer. For example, assuming that both options were trading at
the same price, would you rather purchase an IBM 110 call option that expires
this month or one that expires next year? From a buyer's perspective, you
would obviously rather purchase the one that expires next year. After all, the
chances of IBM moving above $110 within the next year are likely to be far
greater than the chances of it soaring that high within the next month.

In the real world, of course, these two call options would not likely trade at the
same price. Because the option that expires next year has a better chance of
moving higher, its time value will be significantly greater. In this regard, options
are priced somewhat like insurance; the longer the time horizon, the more
expensive they will be.

One other key item to note is that the further "in-the-money" (please see
lesson #2 if you are unfamiliar with this term) an option is, the less time value it
will have. Options that are deep "in-the-money" generally trade at or near
their actual intrinsic value. This is because options with a significant amount of
intrinsic value built in have a very low chance of expiring worthless. Therefore,
the primary value they provide is already priced into the option in the form of
their intrinsic value.

When using options in future, we hope you will consider each option's intrinsic
and time values to help you determine which contracts to choose. In general,
remember that options that are further "in-the-money" are less likely to expire
worthless and therefore have less risk of loss. On the other hand, they are
much more expensive to purchase. Options that are out-of-the-money have
a high risk of expiring worthless, but they tend to be relatively inexpensive. As
the time value approaches zero at expiration, "out-of-the-money" options
have a greater potential for total loss if the underlying stock moves in an
adverse direction.

Conclusion

In this seven-part options series we have covered the basic concepts that you
need to know in order to start using options effectively. The following
summarizes what you have learned so far:

Options Characteristics -- Introduces the basic concepts of how options work.

Factors that Effect Option Prices -- Describes the various factors that
determine an option's price, including the underlying stock price, the option's
strike price, volatility, the risk-free rate, and the amount of time to expiration.
This lesson also introduces put and call trades.

Selling Options -- Outlines the risks and rewards associated with being on the
seller’s side of an option contract.

Portfolio Hedging -- Describes how to use options to hedge an entire portfolio

of stocks.

Spreads and Combinations -- Introduces you to several advanced options

trading strategies that involve the use of two or more option positions.

Collars and Butterflies -- Describes two additional trading strategies that use
multiple options positions.

Intrinsic Value vs. Time Value -- Brings you a closer look at the two key
components of every option's price.

As a final note, we would like to emphasize that options contain unique risks
and may potentially result in significant loss of capital. Because they allow
investors to control large blocks of stock with relatively little capital, options
can create tremendous amounts of financial leverage. Savvy investors use
this leverage to aid in their hedging and speculating activities. However, it
can also be abused. Thousands of overly aggressive investors have been
completely wiped out using options. While this is very uncommon, you should
always be aware that options present the potential for significant losses as
well as gains.

To invest safely, a good rule of thumb is to never invest more in an option than
you could afford to lose on a common stock. For instance, in our recurring IBM
example, if an investor believes that IBM is a good investment and has
$10,000 to invest in the shares, then he/she would be foolish to buy $10,000
worth of call options. A better strategy for the investor would be to determine
the maximum amount of loss he/she is comfortable with, then use that
amount to purchase options. In this case, if 10%, or $1,000, is the maximum loss
that the investor feels would be acceptable, then he/she should only
purchase this amount in options. By using this technique, you'll ensure that you
don't take excessive risks in the options market.

Once again, we hope that you do choose to use options in your portfolio and
take advantage of all the benefits that they offer. Options provide a
wonderful means to not only profit from share price movements, but also to
hedge your portfolio positions and manage your risk. The best part is that you
do not need to work for a Wall Street hedge fund to master the basic
techniques--you can easily learn how to use options profitably on your own. I
sincerely hope that this seven-part series has helped you along on that path.

Thank you for reviewing my options trading lessons. .

Good options trading!

-- Jeff Bishop