NOVICE TRADER
Getting Started With Options
by Joe Demkovich and Eugene Theriot
Rather than shying away from the complexity of options, stick with some simple basics in exploiting them.
You can start paper-trading options despite their daunting reputation for complexity. If you succeed on paper, you'll have taken the first step to extracting profits from the real market. It's true that there are many kinds of options, and options terminology is like a foreign language, but professional traders use options for a good reason. We'll tell you why.
FIGURE 1: In buying, you pay cash for the right to exercise the option.
But first, yes, you can lose 100% of your investment. Of course, it is theoretically possible to do this by buying a stock, but it just doesn't happen. Even if you make an incredibly poor choice of equities, you (usually) won't lose all the value in the next month or two. But it is all too easy to buy an option one week that will be worthless the next. However, options can also be conservative, especially when used in conjunction with equities that you already own.
MYRIAD OPTIONS
Many combinations of options go by special names, but basically, there are only two types: puts and calls. Calls are contracts to buy a fixed number of shares of a specified equity (for our purposes, we will use stocks) for a fixed price on or before a fixed date (Figure 1), while puts are contracts to sell a fixed number of shares of a specified equity for a fixed price on or before a fixed date. To exercise an option is the process by which the holder of an option makes or receives delivery of shares of the security. (See Figures 2 and 3.) The fixed price may be above or below the current market price and is referred to as the strike price. The fixed date is the expiration date and is the third Friday of the month.
If you own a May 120 call on a given stock, you have the right to buy 100 shares of that stock at $120 on or before the third Friday of May. If the current price of that stock is a lot higher than 120, the option will be worth a lot of money. If this is the case, you don't have to exercise the contract (and buy the shares); you could just sell the call contract. Conversely, if the current price is a lot lower than 120, the option will be worth very little. You could sell the option to claim the small value, or you could hold it to expiration and let it expire, worthless.
To complicate matters, you could be long or short the option. If you start out buying a call, then you are long the call. You "bought to open" your position. Then, if you sell the same option (instead of exercising it), you "sell to close" your position. If you started out selling the option, then you are short the contract; you "sold to open" your position. You then "buy to close" if you want to close out your position.
Joe Demkovich and Gene Theriot are partners in a business of options investing. Demkovich has been teaching investing courses for several years and is a retired manager for Ibm, and Theriot is a retired computer engineer. They can be reached via E-mail at joeandgene@att.net or on the Internet at http://JoeAndGene.home.att.net. Option analysis tools are available for download from their Website.
Excerpted from an article originally published in the October 1999 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1999, Technical Analysis, Inc.
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