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How to Invest in Options

The Keys to Understanding Options and Maximizing Gains

Written by Brian Hicks
Posted February 1, 2008

Many of you have expressed interest in better understanding options trading. Others have expressed interest in wanting more options trades. I’m more than happy to oblige.

But before we get into how to invest in options, I wanted to let you know that SCTradingPit has been offering options opportunities, when available, with small cap stocks.

Better yet, we’re putting the finishing touches on an “all options” publication, Options Trading Pit, which should be ready to roll shortly. We’ll keep you in the loop. But until then, I've written a good primer of what options are and how to trade them.

Understanding Options: Capital One Case Study

It was late October 2007 when I bought puts on Capital One (COF :NYSE) for the fourth time.

No one was talking about the credit defaults, bankruptcies and asset write-offs that’ll impact credit-card companies for years to come. Every one ignored the fact that subprime-related credit card companies would end up as mortgage lenders did.

As home equity balances dwindled, credit card balances were up 17% over the last six months. Defaults were up. The average American held seven credit cards at once. Americans owed more than $500 billion in credit card debt. Household debt levels were at a staggering 5.9%. Home debt payments were nearing all-time highs. And, oh yeah, there’s that pesky subprime debt.

This was when COF traded at $70. When this was written, it sat at $45, a 36% gain had I shorted it.

But I was greedy. I wanted more than a 36% gain. Instead, I recommended buying January 65 puts and walked away with 160% in two months.

It was the same approach I used when I racked up these gains, too, over 2007.

  • Fremont General September 2007 12.50 puts — 291% in 16 days
  • Lennar January 2008 25 puts — 279% in 40 days
  • Pulte January 2008 15 puts — 224% in 40 days
  • New Century January 2008 25 puts — 214% in 16 days
  • Centex January 2008 25 puts — 207% in 40 days
  • Countrywide January 2008 27.50 puts — 203% in 69 days
  • Thornburg October 20 2007 puts — 188% in 6 days
  • MGIC Investments December 35 puts — 175% in 80 days
  • Capital One January 2008 65 puts — 160% in 59 days
  • Accredited Home September 2007 7.50 puts — 141% in 4 days
  • Hovnanian November 2007 17.50 puts — 136% in 13 days
  • Radian Group August 2007 60 puts — 122% in 19 days
  • Standard Pacific September 2007 15 puts — 111% in 2 days
  • Autonation January 2008 20 puts — 105% in 49 days
  • New Century January 2008 25 puts — 89% in 1 day

But had I simply “shorted” those underlying stocks above, my average gain would have been about 50%, or peanuts as compared to what we did.

Options Investing Works in Any Market

Don’t get me wrong. We had our fair share of losers, too, but the winners far outpaced the losers, as housing fell apart. Any one that tells you they have 100% success is full of it.

Our top gainer, the Fremont General 12.50 puts produced a 291% gain after it plunged from $15. Had I shorted it, I would’ve realized nothing more than a 67% gain.

It was a trade only a naïve “I believe Bernanke when he says there’s no spillover” trader would have missed.

I was buying puts on everything: banks, credit card companies with subprime exposure, builders, retailers, lenders, you name it. Subprime lending, despite what Bernanke had the public believe, was spilling over in a big way. And I wanted a piece of the downfall.

And we were doing nothing more than capitalizing on a trend. The bearish housing trend was too difficult to ignore.

You see, we knew, despite the bullish cheerleader rants that, “Sub-prime lenders offer adjustable or teaser rates to those with bad credit. Loans like this made up 23% of the U.S. mortgage market in 2006 as compared to the 8% in 2001, according to Yahoo News.

We also knew the problem would soon bubble over, as one in five sub-prime mortgages ended in foreclosure.

We also knew, in February 2007, that the housing market was not bottoming. That sub-prime lenders were doomed. We listened, as JP Morgan’s CEO, James Dimon, was bearish on the sector, saying, “’Mortgages are the one area of sub-prime lending where ‘we really see something taking place that looks like a recession….’”

Even MortgageDaily.com believed “The sub-prime sector still has another year of tough times ahead”, supported by Countrywide Financial, which said, “We’ve got another eight, nine, 10, 12 months of headwinds. You’re seeing 40 or 50 (sub-prime companies) a day throughout the country going down in one form or another. I expect that to continue throughout the year.” Even the Center for Responsible Housing report projected that “2.2 million borrowers will lose their homes and up to $164 billion of wealth in the process.“

We knew we had a ticking time bomb in housing. And we knew the charade of housing bullishness would come crashing down. It was how and why we banked significant 2007 gains in subprime, Alt-A, credit, and homebuilder stocks.

But like I said, had I simply shorted the underlying stocks, my average gain would’ve been 50%.

Are gains like these still achievable? You bet. But you must understand options , which brings us to the basics...

Options Investing 101: Understand Options, Maximize Gains

If options scare you, or you’re one of those investors that won’t give it a shot, let me preface this by saying options aren’t as difficult as you may think.

Let’s go over the basics. An option is a contract that gives an investor the right, but not the obligation, to buy or sell a stock at a specific price on or before a specific date, or expiration date.

Just like stocks, investors can buy and sell options, including call options and put options.

Call Options give the buyers the right to buy an underlying security at a specific price on or before a specific date of expiration.

Put Options give the buyers the right to sell an underlying security at a specific price on or before a specific date of expiration.

When you place options trades, just concern yourself with "Buy to Open" and "Sell to Close".

Buy to open allows you to open a long position in an option trade. Sell to Close allows you to close that long position in an option trade.

Don't be concerned with "Sell to Open" or "Buy to Close" at this stage of the game. Selling to Open allows you to take a short position in an option. Buying to Close allows you to cover that short position.

Options Facts

For those of you that don’t know, a call option, for example, may show a price of $2, but you’d pay $200 (price x 100 shares).

A strike price is the price that the underlying stock can be bought or sold at, as detailed in the option contract. Options are identified by month of expiration, whether they are a put or call, and by a strike price (or the price you believe the underlying stock will reach).

For example, an ABC January 2008 25 call would refer to a call option on ABC with a strike price of 25 that expires in January 2008. Also keep in mind that options expire the third Friday of every month. If for example, you bought the April 25 calls, these would expire the third Friday of April.

Options have limited lifetimes. At expiration, options cease to exist. If you buy an option, you either exercise it (buy or sell the underlying security) or it will expire worthless.

Intrinsic Value and Time Value of Options

Intrinsic value represents how much the option is worth if you exercise it right now. You can find intrinsic value by comparing the strike price to the market price of the underlying security. An option with intrinsic value is in-the-money. It’s current price (CP) minus strike price (X).

If the stock’s current price is greater than the option strike price, the remainder is the intrinsic value. In the case of a call, if the price of the underlying stock is above the strike price, the call is in-the-money. If ABC is trading at $40, and you have a $35 call, you can buy the stock at $5 less than everybody else. This is the call's intrinsic value.

If the strike price is greater than the stock price, the intrinsic value is zero.

In the case of a put, the opposite is true. Intrinsic value would be calculated with X minus CP. A put is in-the-money when the strike price is above the market price of the stock. If you own an ABC $35 November put, and ABC is trading around $30, you are $5 in-the-money. This represents the intrinsic value of the put.

If the strike price of a call is above the price of the stock, the call is out-of-the-money. If you own a XYZ November US$10 call when XYZ is at US$8, there s no reason to exercise it, since you would automatically lose US$2. If the strike price of the call is equal to the price of the stock, the call is at-the-money. In both cases, you don t gain anything by exercising the call. The call lacks intrinsic value.

A put is out-of-the-money if the strike price is below the price of the underlying security. An HIJ $80 put is US$12 out-of-the-money when HIJ is at US$92.

If I’ve lost you at all, don’t panic. As with everything, “practice makes perfect.”

There’s also time value. This is any value of that option other than intrinsic. If ABC is trading at $40 and the ABC 35 call option trades at $6, then we’d say it had a time value of $1 ($6 option price minus $5, or intrinsic value). This is the “insurance premium” of the option.

Delta: Not just an Airline

Delta is based on the underlying security value. Delta is the amount by which an option's price will change for a one-point change in the price of the underlying asset. Call options have positive deltas, while put options have negative deltas.

A 0.50 delta means that for every US$1 gain in the stock, a call option gains 50 cents in premium. A -0.50 delta means that for every US$1 loss in the stock, a put option gains 50 cents in premium.

That’s it. Those are the bare bones basics of trading options.

If I’ve lost you at all, I do apologize. And I’m more than happy to help. Leave a question or comment in the comment section below, and I’ll try to answer all of them.

Ian L. Cooper
http://www.wealthdaily.com

P.S. Investors are scared. And they should be.

The U.S. service sector, which accounts for about 90% of GDP plunged into contraction during January. The ISM non-manufacturing number dropped to 41 in January from a December read of 54. This is the first time since 1993 that the ISM number has been below 50. And it’s the lowest read since 2001.

The number was so bad that the ISM released the news at 9 a.m. ET, an hour ahead of schedule, in an effort to suppress any leaks to the broader market.

But as we’ve mentioned, the Fed will attempt to prop up the economy with further rate cut aggression, met with a Bush Administration stimulus plan. But there’s no guarantee that either will snap the economic melee.

But… relax. Everything will be fine.

There's always a bull market somewhere, despite the fear. It's time to hunt in those very bull markets, as scarce as they may be.

Despite recent and wild market fluctuations, Cooper locked in 62% and 43% gains on Millennium in an average of eight days, a 3-day $3.36 gain on half of NutriSystem, and is still holding the second half with a $5 gain.

For more on SCTradingPit.com, click here.

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