Stock Options (for Beginners)

[aquaswim47]

Lets say, you think the European market is going to tank and the Pacific and US markets will boom. What would you do? You would buy VPL and VTI and short VGK. You might also just short 100 shares of VGK at $7,932 and use the proceeds to buy 1 call option contract. A call option contract gives you the right, but not the obligation to buy 100 shares of stock.

Why might you short a stock and have a call option? Because a put option is more expensive than a call option. Take NEW in Febraury of 2007. It was at $15 per share. Puts were extremely expensive and got more expensive as the stock price declined. Calls, on the other hand, got cheaper. Thus, even though you had to pay four commissions instead of two, it was less expensive to short NEW and buy a call option as a hedge against a potential buyout. The risk is that the buyout would wipe out your short position and once you resolved it with the broker, your call option declined in value or became worthless. However, if you exercise the call at the EXACT SAME TIME as when you receive a margin call, you would be fully protected assuming that call option writer doesn't default. I haven't really read up on the OCC to see if there's any insurance against writer default. This is the main reason why I like a put option buyer, call option buyer, or call option writer to have significant financial resources shall a near bankrupt stock triple in value due to a takeover.

Lets say, though that you believe the US and European market are going to do well and the Pacific region is going to tank. Since the Pacific region is volatile, you want to hedge your short position just like you'd want to hedge a short position on QQQQ. You would sell short 100 shares at $72.66 (receiving $7,266) and buying 1 call option contract. If you have sufficient financial resources to avoid a margin call, you are fully protected, but do lose the insurance premium of the call option (not bad if you're not exactly certain of when the market will drop in value). Take the Nasdaq in November of 1999. You would have lost 85% on your short position (assuming no margin = I hate margin) by March of 2000 since the Nasdaq went up 85% during that period. If you had one call option contract, you would have been fully hedged in your position and fully benefit from shorting the stock in March of 2000 to March of 2003 (a 72% profit less any call option premiums less commissions). You'd get any increase from the strike price in regards to the call option less the time value lost.

The problem with call options is the time value declines rapidly in value and you need an increase in the intrinsic value to make up for the loss in time value. Thus, for the beginner investor, call options are not a smart strategy. If you wish to gain from a stock, I'd either recommend writing puts or buying the stock and not using call options. As a beginner, I would limit your call option percentage to 0.5% of your money (or 1/200 of your money). You can increase it to 5-10% when you have a really strong grasp of options (1/20 of your money). I really think with options you should only invest in them if you completely understand what you're doing. In other words, I wouldn't invest any of your money in call options as a beginner investor (for at least 2-5 years after you have begun investing). You had better tried it out, understand it, know how they work, and the potential pitfalls.

I do advise using call options as a hedge on your short positions (even as a beginning investor). What worries me is a bankrupt stock that is bought out as the value of the deal might wipe out your short position and then the stock declines in value so that your call option doesn't cover what you lost in the short. In general, however, call options are an excellent hedge against a short position of 100 shares of stock.

[rayjman]

There is a nice skew on the difference sometime, but it's useful to read the bid/ask and definitely to some simple math before a buy decision is made. One thing that shorts require is: MARGIN (not everyone has it) & buy power. Not everyone has it. Shorting call options has been a good strategy for me as of late as the market goes up or if I have a stock that has had a nice rally. I don't really trade my cores too much anymore and keep bringing in Theta (time decay)......on most of my options.

I like the last part on recommending call options as a hedge against short positions. I wasn't short too many stocks last year without calls. They were cheap as well because nobody wanted them in a downtrending market (and they got cheaper of course!).
When I saw Toyota blew up to the upside in Germany I always thought to myself.......wow.....I hope those people that were short had upside calls (at least the a bit out of the money) to minimize their loss.

One simple way I've thought about options as well is to build a shopping list, invest 2-5% of your portfolio in slightly out of the money options on those and the rest in cash only (95-98%).
That way if the market rallies nicely you don't miss out that month into options expiry and you bought some stocks on the cheap. If the market doesn't rally, oh well, but you are still out a lot less than actually being entirely fully vested in the market with stocks....
As far as bankruptcy is concerned, that's a tough one. My broker only lets me cover the short call @.05, so sometimes I setup a limit order and get rid of it and core stock the position if it goes down that low.

[rayjman]

I wouldn't recommend selling puts as a strategy (unless they are cash secured and you want to own the stock). Selling puts have a loss of......yep you guessed it, same as short stock: UNLIMITED. As a beginning investor on options (if you have never used them before). I would recommend one of the 2 following methods:
1. PAPER TRADE them (write them down and see how they work).
2. Use CBOE - Home (once you register, they have a free tool there you can use that links to OptionsXpress and you can trade, but I think it's 15 minute delayed).

[stockrookie09]

i like call options because if you own Call Options, Stock Options contracts allowing you to buy the stock in future at the current agreed price, and the stock rallies strongly, that call option becomes more and more valuable due to the fact that you are able to still buy it at the lower agreed price.

[avaritia]

Originally Posted by rayjman

Selling puts have a loss of......yep you guessed it, same as short stock: UNLIMITED.

I respectfully disagree. First, you are long on the stock. The potential loss of selling puts is limited like buying stock. They can only both go down to zero. Sellling calls has unlimited losses ...theoretically; but what stock will ever go up to infinity?

Hehe, I remember there was this one oddity. I think it was the preferred shares of freddie mac or something, but the stock price was listed in the millions of dollars... I think it was some sort of error

[aquaswim47]

Originally Posted by avaritia

I respectfully disagree. First, you are long on the stock. The potential loss of selling puts is limited like buying stock. They can only both go down to zero. Sellling calls has unlimited losses ...theoretically; but what stock will ever go up to infinity?

Hehe, I remember there was this one oddity. I think it was the preferred shares of freddie mac or something, but the stock price was listed in the millions of dollars... I think it was some sort of error

I agree. But talk about high fliers; even BRK-A has gotten hit hard this year.

[IvanJameer]

Guys, It is very cool to read the longggg posts on stock market trades and other trades, I too agree with

Originally Posted by shria80

This time I can't assume any thing in stock market. It is unpredictable.

Stock market is unpredictable, however, there are other trade markets such as real estate market, IT market are really strong ones, We can judge the profit there via past outcomes, but in case of stock market, it cannot be done, Now we are under economical crisis -- it is better to away -- that will be a wise idea,

[zoozoo]

Originally Posted by shria80

This time I can't assume any thing in stock market. It is unpredictable.

Yes but atm imo it's a great time to buy if you have extra funds sitting around. I highly doubt the stock market will crash further than it has now, I do however see many stocks going up.

Clearly this will not be in the next year or so, but a long term investment for example (5 to 8 years)

But clearly don't gamble with your life savings.