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Speculative/High Risk Products: Options
 
Options
Want to learn more about Options? Here are some links to get you started:
   
  Call Option
   
  Put Option
   
  Help With Portfolio Protection
   
  Help Generate Income With Your Portfolio
   
Speculation/Leverage
A Call Option
  In the case of an equity option, a contract that gives the buyer the right, but not the obligation, to purchase a set amount of stock (usually 100 shares) at a predetermined price anytime before the contract expires (American Style option) or at expiration only (European Style Option). The predetermined price is known as the strike price.
   
A Put Option
  In the case of an equity option, a contract that gives the holder the right, but not the obligation, to sell a stock at a set price for limited period of time. The seller or writer of the option is obligated to buy the stock at the strike price in the event that the option is assigned.
 
  Holder (Buyer) Writer (Seller)
Call Option
Right to buy Obligation to sell
Put Option Right to sell Obligation to buy
 

In general, there are three main reasons to use options as part of your overall investment strategy.

1. Help with portfolio protection

2. Help to generate additional income on your portfolio

3. Speculation/leverage

Help With Portfolio Protection

  One of the most conservative strategies for using options is to help ensure your portfolio against sudden downward pressure on stock prices. To help protect portfolio value, investors often buy puts as a hedge. For what amounts to be a fairly minimal investment, you can secure the right to sell your stock at a particular price (a "put") regardless of what the market is doing. By purchasing a protective put, an investor increases their breakeven point of the stock by the cost of the put and if the stock price rises instead of falls, this strategy may limit the upside potential by the cost of the put. Before using this strategy, it is important to consider the tax implications because no matter what direction
the stock moves, the purchase of a protective put terminates a stock's holding period for tax purposes.

The way this works is fairly straightforward. Let's imagine you decided to buy 1000 shares of XYZ Corporation for $47. To protect your $47,000 investment, you might consider buying puts.

Since each put controls 100 shares, you would need 10 contracts to protect 1,000 shares. By choosing a strike price of $45 and an expiration date several months away, you would lock in the right to sell your shares with a maximum loss of $2,000 ($47 purchase price - $45 strike price x 1,000 shares) plus the cost of the puts. Of course, the best scenario would be for the stock to increase in value so the puts would expire worthless. In either case, knowing that you'll be able to sell your shares at $45-even if the stock drops to $30- might just help you sleep easier.
   
Help Generate Additional Income on Your Portfolio
  Another common, relatively conservative strategy is covered call-writing. Many investors use this strategy to help generate additional income from stocks they have in their portfolio. A covered call strategy can provide a stock-owning investor limited downside protection in return for limited upside participation as any participation in a stock price increase is capped at the strike price. Also, like stock ownership, the downside loss potential can be substantial as the underlying shares could possibly decline to zero.

Before using this strategy, it is important to consider the tax implications because you may have to pay capital gains on the sale of the stock. If this isn't a big issue for you, then it's best to pick stocks in your portfolio that tend to be somewhat volatile. The options on more volatile stocks are more expensive so they generate more potential income when you sell the covered calls. If you would rather be more conservative, choose a less volatile stock because it is less likely you will be forced to sell it. The trade-off is that you won't earn as much income because the options on less volatile stocks are less expensive. In either case, here's how the strategy works:

Let's imagine that one of your key holdings is a company that spent the past year between $59 and $68 per share. You currently have 1,000 shares and the stock is trading at $67. If you sold 10 calls or less against the stock in your account, they would be considered "covered" because you wouldn't have to buy shares on the open market in the event of an assignment. For this reason, the position is far less risky than uncovered (naked) calls that, by definition, are written without stock as collateral.

If the $70 calls are trading at $3, you could sell 5 contracts and earn $1,500 ($3 x 5 contracts x 100 shares). Now, all you have to do is hope the stock remains below $70. If it does, you keep the $1,500 and all of your stock. If the stock jumps to $72, you have two choices. First, to keep the stock, you could buy the calls back. While this may result in a loss, for tax reasons it could be preferable to incurring capital gains. Your other option would be to wait for the assignment and sell 500 shares to the option holder at $70 per share. In this case, you still keep the $1,500 premium you collected from selling the calls. In addition, you capture the profit associated with the stock's move from $67 to $70.
   
Speculation/Leverage
  For investors with a high level of risk tolerance, options provide ample opportunity to use relatively moderate sums of money to leverage sizable positions. For a fraction of what it would cost to buy large blocks of shares in high-flying volatile companies, investors can buy calls giving them the right, but not the obligation, to buy shares at a specific price (strike). Although options provide potential opportunities, unlike stock, options do not pay cash dividends or convey voting rights. Also, options may expire worthless and an options buyer risks the entire amount paid plus any commissions paid.

If a stock trades at $40, it would take $20,000 to buy 500 shares. Using options, the same investor might buy ten 40 call contracts at $7. Now, for just $7,000 (10 contracts x $7 x 100 shares per contract), the investor owns the rights to buy 1,000 shares of stock at $40, any time before the call options expire. If the stock price is $60 at expiration, the options
will be worth $20 each ($60 - $40) or $20,000 (10 contracts x $20 x 100). The investor will have a profit of $13,000 on a $7,000 investment.

In contrast, the investor who paid $40 for 500 shares spent $20,000 to make $10,000 ($60 - $40 x 500 shares). That's the power of leverage. However, the risks are equally high. If the stock doesn't move, the investor who paid $7,000 for the $40 calls will lose the entire investment. Likewise, the investors who bought the stock will have lost nothing because they still own the stock.
 
Value at Expiration
Stock Price
Stock Profit (Loss)
Option Profit (Loss)
20
($10,000)
($7,000)
30
($5,000)
($7,000)
40
$0
($7,000)
50
$5,000
$3,000
60
$10,000
$13,000
70
$15,000
$23,000

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