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.