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
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.
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
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
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.
PowerShares DB US Dollar Index Bullish Fund (
is an exchange-traded fund (
) 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.
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 (
) 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 (
) in 14 days!