AARP Getting Started in Options

Michael C. Thomsett

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9781118241646
• eBook ISBN: 9781118241769
• Edition: 8
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

AARP Digital Editions offer you practical tips, proven solutions, and expert guidance.

During the recent market turmoil, option trading volume actually increased, but many are still unsure of the opportunities that options present, simply because they don't fully understand how this market works. With Getting Started in Options, Eighth Edition, author Michael C. Thomsett looks to change this. In non-technical, easy-to-follow terms, this accessible guide thoroughly demystifies the options markets, distinguishes the imagined risks from the real ones, and arms investors with the facts they need to make more informed decisions.

• Opens with an introduction commenting on the recent market turmoil and the growing importance of options
• Contains new chapters on futures and index options
• Includes sidebar definitions and easy-to-follow examples that anyone can understand

Besides new examples, updated charts, and timely additions to reflect important changes in the markets, this edition also includes discussions on other important options issues, such as: how to calculate options returns; "test run" activities to try out new theories; and much more.

Chapter 1

Calls and Puts: Defining the Field of Play

Nine-tenths of wisdom is being wise in time.

—Theodore Roosevelt, speech, June 14, 1917

Options are amazing tools that can help you expand your control over your portfolio, protect positions, reduce market risk, and enhance current income. Some strategies are very high risk, but others are extremely conservative. This is what makes the options market so interesting. The variety of creative uses of options makes it possible to tie in profits in the most uncertain of conditions, or to pursue income opportunities without being exposed to even the most volatile markets.

Because the option is an intangible device, its cost is only a fraction of stock prices. This makes it possible to control shares of stock without assuming the market risks. Each option controls 100 shares, so for approximately 10 percent of the cost of buying shares in a company, you can use options to create the same profit stream. This makes your capital go farther while keeping risks very low.

This idea—using intangible contracts to duplicate the returns you expect from well-picked stocks—is revolutionary to anyone who has never explored options trading. Most people are aware of the two best-known ways to invest money: equity and debt. An equity investment is the purchase of a share of stock or many shares of stock, which represents a partial interest in the company itself. Shares are sold through stock exchanges or over the counter (trades made on companies not listed on an exchange). For example, if a company has one million shares outstanding and you buy 100 shares, you own 100/1,000,000ths, or .0001 percent of the company.

equity investment

an investment in the form of part ownership, such as the purchase of shares of stock in a corporation.

share

a unit of ownership in the capital of a corporation.

When you buy 100 shares of stock, you are in complete control over that investment. You decide how long to hold the shares and when to sell. Stocks provide you with tangible value, because they represent part ownership in the company. Owning stock entitles you to dividends if they are declared, and gives you the right to vote in elections offered to stockholders. (Some special nonvoting stock lacks this right.) If the stock rises in value, you will gain a profit. If you wish, you can keep the stock for many years, even for your whole life. Stocks, because they have tangible value, can be traded over public exchanges, or they can be used as collateral to borrow money.

Example

Equity for Cash: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees into your account. You receive notice that the purchase has been completed. This is an equity investment, and you are a stockholder in the corporation.

Example

Partway There: You buy an automobile for $10,000. You put down $3,000 and finance the difference of $7,000. Your equity is limited to your down payment of $3,000. You are the licensed owner, but the financed balance of $7,000 is not part of your equity.

debt investment

an investment in the form of a loan made to earn interest, such as the purchase of a bond.

The second broadly understood form is a debt investment, also called a debt instrument. This is a loan made by the investor to the company, government, or government agency, which promises to repay the loan plus interest, as a contractual obligation. The best-known form of debt instrument is the bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their operations and projects through bond issues, and investors in bonds are lenders, not stockholders.

When you own a bond, you also own a tangible value, not in stock but in a contractual right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall in value based on the interest rate a bond pays compared to current rates in today’s market. In the event an issuer goes broke, bondholders are usually repaid before stockholders as part of their contract, so bonds have that advantage over stocks.

Example

Lending Your Money: You purchase a bond currently valued at $9,700 from the U.S. government. Although you invest your funds in the same manner as a stockholder, you have become a bondholder; this does not provide any equity interest to you. You are a lender and you own a debt instrument.

Example

Helping a Friend: A good friend wants to buy a car for $10,000, but has only $3,000 in cash. This friend asks you to lend him the balance of $7,000 and offers to pay interest to you. The $7,000 you contribute is a debt investment, and the interest you earn is income on that investment. When you act as lender, you have made a debt investment.

The third form of investing is less well known. Equity and debt contain a tangible value that we can grasp and visualize. Part ownership in a company and the contractual right for repayment are basic features of equity and debt investments. Not only are these tangible, but they have a specific life span as well. Stock ownership lasts as long as you continue to own the stock and cannot be canceled unless the company goes broke; a bond has a contractual repayment schedule and ending date. The third form of investing does not contain these features; it disappears—expires—within a short period of time. You might hesitate at the idea of investing money in a product that evaporates and then ceases to have any value. In fact, there is no tangible value at all.

Smart Investor Tip

Options are intangible and have a limited life span. The main advantage is that options allow you to control 100 shares of stock without having to buy those shares.

So we’re talking about investing money in something with no tangible value, which will be absolutely worthless within a few months. To make this even more perplexing, imagine that the value of this intangible is certain to decline just because time passes by. To confuse the point even further, imagine that these attributes can be an advantage or a disadvantage, depending on how you decide to use these products.

These are some of the features of options. Taken alone (and out of context), these attributes certainly do not make this market seem very appealing. These attributes—lack of tangible value, worthlessness in the short term, and decline in value itself—make options seem far too risky for most people. But there are good reasons for you to read on. Not all methods of investing in options are as risky as they might seem; some are quite conservative because the features just mentioned can work to your advantage. In whatever way you might use options, the many strategies that can be applied make options one of the more interesting avenues for investors. The more you study options, the more you realize that they are flexible; they can be used in numerous situations and to create numerous opportunities; and, most intriguing of all, they can be either exceptionally risky or downright conservative.

Smart Investor Tip

Option strategies range from high risk to extremely conservative. The risk features on one end of the spectrum work to your advantage on the other. Options provide you with a rich variety of choices.

option

the right to buy or to sell 100 shares of stock at a specified, fixed price and by a specified date in the future.

An option is a contract that provides you with the right to execute a stock transaction—that is, to buy or sell 100 shares of stock. (Each option always refers to a 100-share unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future. When you have an open option position, you do not have any equity in the stock, and neither do you have any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the fixed price.

Since you can always buy or sell 100 shares at the current market price, you might ask: “Why do I need to purchase an option to gain that right?” The answer is that the option fixes the price of stock, and this is the key to an option’s value. Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable, which makes stock market investing interesting and also defines the risk to the market itself. As an option owner, the stock price you can apply to buy or sell 100 shares is frozen for as long as the option remains in effect. So no matter how much price movement...

Table of contents

• Title Page
• Copyright Page
• Acknowledgements
• Element Key
• Introduction
• Chapter 1 - Calls and Puts: Defining the Field of Play
• Chapter 2 - Opening, Closing, Tracking: How It All Works
• Chapter 3 - Buying Calls: Maximizing the Rosy View
• Chapter 4 - Buying Puts: The Positive Side of Pessimism
• Chapter 5 - Selling Calls: Conservative and Profitable
• Chapter 6 - Selling Puts: The Overlooked Strategy
• Chapter 7 - Choosing Stocks: Finding the Right Ingredients
• Chapter 8 - Strategies in Volatile Markets: Uncertainty as an Advantage
• Chapter 9 - Combined Techniques: Creative Risk Management
• Chapter 10 - Paper Trading: A Test Run of the Theory
• Chapter 11 - Options for Specialized Trading: Leveraging the Technical Approach
• Chapter 12 - Leveraging Your Leverage
• Chapter 13 - Trading Index Options: Playing the Broader Market
• Chapter 14 - Risk and Taxes: Rules of the Game
• Chapter 15 - Calculating the Return: A Complex Aspect to Options
• —Glossary—
• —Recommended Reading—
• Index