Understanding and Using Options

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Mention that you trade options at a party and you are likely to hear something like "Wow, that's gutsy."  That's because investors have heard stories about people losing their shirts trading options or they've heard statements to the effect that 75% of options expire worthless. But the fact is, there are many ways to use options, and investing with options can actually be less risky than investing in stocks.

Let's start with the basics. What is an option? There are two kinds of options: puts and calls.

A put allows the buyer to sell the underlying stock at a specific price by a certain date in the future. Simple right? OK, maybe not, so let's breakdown that last explanation. If you own one IBM January 145 Put, you have the right to sell 100 shares of IBM stock for the price of 145 between now and the January options expiration date (all options expire on the third Friday of the expiration month).

Put buyers profit when a stock moves lower. If shares of IBM trade below 145, your put option has value. If shares of IBM drop to 140 and you have the right to sell it at 145, this means your 100-share option is worth $500.

Puts can also be used as insurance. If you own IBM stock and want to protect yourself from a downward move in the stock, you could buy one put option for every 100 shares you own.

The second kind of option is a call. A call allows its owner to buy the underlying stock at a specific price by a certain date in the future. Call buyers profit when a stock moves higher-the opposite of a put.

If you own one IBM January 145 Call, you have the right to buy 100 shares of IBM for 145 between now and the third Friday in January. When the stock trades above 145, your call option has value. So if IBM is trading at 150 and you have the right to buy it for 145, your call option is worth $5, which is really $500.

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There are many different ways to use options in a trading strategy but today we'll stick to buying puts and calls-easiest type of trade to explain and execute. When you buy puts or calls, you are simply making bets that a stock will move higher (a call) or move lower (a put).

These are the only kinds of trades we recommend in Cabot Options Trader. We recommend either a put or a call on a given stock. Using the IBM example, if our indicators say that IBM is poised for a rally, we would recommend a call on IBM. And we also have to choose a strike price and the month in which we want to buy the call.

With IBM trading at 145, we can choose an option that is "in-the-money." (In-the-money means the option's strike price is below the current stock price.) In the case of IBM, the 140 strike and all strike prices lower than 140 are in-the-money. The amount they are in-the-money is called the intrinsic value.  For instance, the January 140 strike call is currently trading at $6.50. The intrinsic value of this option is $5.00 and the other $1.50 is the time value. You want to choose the strike price that is the right balance between risk and reward.  In Cabot Options Trader, we usually go one or two strikes in the money.  This leaves us ample opportunity to double our money while keeping our risk under 50% typically.

When it comes to choosing a month, you can choose the front-month (the nearest expiration month) or choose February, April, July or January of 2012 or 2013 (LEAPS, or Long-Term Equity Anticipation Securities, publicly traded options contracts with expirations longer than one year). If you think the stock is going to rally in the next few weeks, choose the January option. If you think the rally might take a month or two, you would want to buy the April option. I always recommend buying a little more time than you think you need for the stock to move to your desired price.

If there is one thing you should remember, it is this: The more in-the-money an option is, the more conservative it is. And the more time between now and the expiration of the option, the more conservative it is.

With options, you can be as aggressive as you want; buy a January 155 call for $0.40 or buy a January 2013 130 Call for $25. The first one is a serious gamble and is either going to be a strikeout or a serious home run.  The second one is very conservative (which is why it's expensive) but to make a decent rate of return, it will take a huge move by the stock.

Factors like the amount of time you buy and whether you are buying in-the-money options or out-of-the-money options will determine how risky or conservative the trade is, but either way you will be investing far less money than you would if you bought 100 shares of IBM stock. At 145 per share, 100 shares would cost $14,500. The January 2013 130 Call would cost $2,500.

Options give you the ability to be involved in opportunities at a much lower cost than investing in shares of the stock. Thanks to the leverage that options provide, you can make almost as much money as you would on the stock but with a significantly lower investment amount.

To continue with the example of IBM, if shares move from 145 to 190, the 100 shares you own will give you a gain of $4,500. The same move in the stock would cause the option to move to $60 and give you a gain of $3,500.

Just remember that leverage works both ways. If IBM's stock drops to 125, you'll lose $2,000 (13.8%) on the stock and you'll lose all $2,500 (100% of your investment) if you bought the option. This is one reason why you want to make smaller bets when you are dealing with options.

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Now that you have a basic understanding of how to buy options, let me show you a trade I think Cabot Wealth Advisory subscribers might want to take advantage of.

The PowerShares DB US Dollar Index Bullish Fund ( UUP ) is an exchange-traded fund ( ETF ) that goes up when the U.S. dollar moves higher against other currencies. The U.S. dollar got beaten up pretty good from June through October as the economy struggled and domestic interest rates hit record lows. The dollar's decline took UUP down to the 22 level for the third time since the ETF launched in early 2007. UUP has since turned higher and is trading just above 23.

It now looks as though UUP is headed up above 26 with a target of 26.50. If you buy the stock here and it goes up to 26.50, you would make just shy of 15%.

However, because the UUP is not very volatile, you can buy the June 21 Call for $2.28, or $228 per (100-share) contract. If UUP goes up to 26.50 as I expect it to, the June 21 Call will be worth at least $5.50 for a gain of 141%--almost 10 times greater than the gain you would get buying shares of UUP.

On the downside, I recommend exiting the trade on a close below 22. If shares decline below 22, the option should be worth approximately $1.10-$1.15, for a loss of around 50%. This gives a reward-to-risk-ratio of 2.82.

Here is the beauty of this trade. If you were to buy 1,000 shares of UUP, you would pay just over $23,000 at the current price. A 15% gain would net you $3,450.

But if you were to buy 10 of the June 21 strike calls, it will cost you $2,280 and a gain of 141% would give you a gain of $3,215. So the gain for the option is almost as much as the gain for the stock-but you are risking 90% less!

On the downside, if the stock drops from 23 to under 22 and you own 1,000 shares, you lose just over $1,000. If the option drops 50% because the stock drops under 22, you stand to lose $1,140.

So let's look at the whole picture.

If you buy shares of UUP at 23 with a stop loss at 22 and shares rise 15%, you would invest $23,000 to make $3,450, with a downside risk of $1,100.

If you buy the option, you invest $2,280 with the opportunity to make $3,215 and the downside risk of $1,140.

This is the perfect situation to play a longer-term option.

Sincerely,

Rick Pendergraft
For Cabot Wealth Advisory

P.S. Leverage your investments to make money in all markets! Cabot Options Trader Editor Rick Pendergraft uses the market's volatility to bring his subscribers huge profit-making opportunities. Just check out these gains from the last three months: A 109% gain on a Call on Pride International ( PDE ) in only 15 days! An 88% gain on a Put on Arcelor Mittal (MIT) in 13 days! A 70% gain on a Call on Linear Technology ( LLTC ) in 14 days! Join today!



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: ETF , LLTC , PDE , UUP

Cabot Heritage Corporation

Cabot Heritage Corporation

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