Covered Calls and LEAPS -- A Wealth Option E-Book

Joseph R. Hooper

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 321

Veröffentlichungsjahr: 2010

Beschreibung

In this one-of-a-kind "how-to" guide, Joseph Hooper and AaronZalewski provide step-by-step instructions for generating largemonthly cash returns from almost any stock investment--whileat the same time decreasing the risk of stock ownership. Filledwith in-depth insights and proven techniques, this book is thedefinitive, rule-based guide to covered calls and calendar LEAPSspreads.

Leseprobe

Table of Contents

Title Page

Copyright Page

Foreword

Preface

OPTIONS ARE NOT JUST A HIGH RISK/HIGH RETURN INSTRUMENT

CHAPTER 1 - An Introduction to Options

MARKET BASICS

OPTIONS BASICS

PART I - Covered Calls

CHAPTER 2 - An Introduction to Covered Calls

OPTION SELLERS/WRITERS

COVERED CALLS: THE RIGHT MIND-SET

CHAPTER 3 - Entering New Covered Calls Positions

SOME BASICS

THE RULES FOR ENTERING NEW COVERED CALL POSITIONS IN THE U.S. MARKET

USING THE CSE SCREENER TO SELECT U.S. COVERED CALLS

USING PRICE CHARTS

INVESTING IN NON-U.S. MARKETS

CHAPTER 4 - Management Rules

CLOSING POSITIONS ON THE DELTA EFFECT

THE MID-MONTH RULE

SECONDARY CALL SALES

THE TETHERED SLINGSHOT FOR INCOME AND THE SELLING HIGH RULE

SELLING CALLS ON EXISTING STOCK HOLDINGS

IMPLEMENTING A COVERED CALL STRATEGY USING OTHER STOCK SELECTION METHODS

CHAPTER 5 - Defensive Techniques

BASIC DEFENSIVE TECHNIQUES

ADVANCED DEFENSIVE TECHNIQUES

PART II - Calendar LEAPS Spreads

CHAPTER 6 - An Introduction to Calendar LEAPS Spreads

ADVANTAGES OF THE LEAPS TECHNIQUE

USING LEAPS FOR COVER

CHAPTER 7 - Entering New LEAPS Positions

SOME BASICS

THE RULES FOR ENTERING NEW LEAPS POSITIONS

USING THE CSE SCREENER TO FILTER LEAPS INVESTMENTS

USING PRICE CHARTS WITH THE LEAPS TECHNIQUE

THE BUYING LOW RULE FOR LEAPS

CONSTRUCTING A LEAPS POSITION

CHAPTER 8 - Management Rules

THE 10c AND 5% BUYBACK RULES

THE DELTA LOW BRIDGE

SECONDARY CALL SALES: MANAGING LEAPS THAT HAVE NOT SOLD FOR A PROFIT

CHAPTER 9 - Defensive Techniques

SURROGATE LEAPS REPLACEMENT

AVERAGING DOWN

REPOSITIONING A LEAPS

ROLLING OUT

CONCLUSION

APPENDIX A - Quick Reference Guide

APPENDIX B - Foreign Exchange Risk

APPENDIX C - Brokerages and Order Types

APPENDIX D - Using ETFs and HOLDRs for Diversification

APPENDIX E - Compound Stock Earnings Support Services

Glossary

Index

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Library of Congress Cataloging-in-Publication Data:

Hooper, Joseph, 1943-

Covered calls—A wealth option : a guide for generating extraordinary monthly income / Joseph Hooper And Aaron Zalewski. p. cm.

Includes bibliographical references and index.

ISBN-13 978-0-470-04470-4 (cloth/dvd : alk. paper) ISBN-10 0-470-04470-5 (cloth/dvd : alk. paper)

1. Options (Finance) 2. Stock options. I. Zalewski, Aaron, 1980- II. Title. III. Title: Covered calls.

HG6024.A3H66 2006

332.63’2283—dc22 2006015461

Foreword

Brilliant book. Anyone who has read any of my work knows that I believe buying, holding, and praying is not an optimal financial strategy. Joseph Hooper and Aaron Zalewski have done an excellent job making a complex subject simple enough for someone like me to understand.

As most of us know, investors invest for two basic things: capital gains and cash flow. Most people invest for capital gains, which is simply buying something and hoping the price goes up. Investing for cash flow is investing for a steady stream of income. Of the two, investing for cash flow requires the most skill. Anyone can deceive themselves by thinking, “The price will go up in the future.” Or anyone can be suckered into a sales pitch that goes: “Prices have gone up over the past five years . . . so you better buy now.”

The reason I love this book is because the authors have made investing for cash flow simple. I like the analogy in their Preface of planting trees and growing a forest to be cut down as an example of investing for capital gains versus planting fruit trees to harvest and replenish on a regular basis as the example of investing for cash flow. Obviously, the more savvy investors invest for both capital gains and cash flow. They want a forest and the fruit. They want money today and tomorrow.

Regardless, even if you never plan on investing in stocks or covered calls, this is an excellent book for anyone who wants to look into the mind of a professional investor. You see, the investment strategy discussed in this book does not apply only to stocks. This investment strategy works for real estate as well. Rarely do I buy a stock or piece of real estate without first knowing that I will receive cash flow and capital gains. In other words, this book is not about an asset class but more about a class of investor that likes to win, not gamble.

ROBERT KIYOSAKI Author of Rich Dad, Poor Dad

Preface

One can think of the accumulation of a stock portfolio through time as the cultivation of a forest full of trees. Traditional Street mentality encourages investors to plant trees throughout their working lives and rely on appreciating markets to grow the forest over the long term.

Once our working lives are finished and active income ceases, the Street then encourages investors to begin cutting down the forest to provide income in retirement. The hope is that the forest has grown large enough over time to withstand the depletion in retirement. In our experience, this level of growth is a rarity for the average American.

What the Street has overlooked is that simple and very conservative cultivation can transform the forest into an orchard of fruit-bearing trees. Fruit-bearing trees generate cash income on a monthly basis. For investors who want to grow their assets, rather than eating the fruit each month, the fruit can be left to fall on fertile soils to grow more trees and thus to compound the growth of the forest through time. For investors who are in retirement, the fruit can be picked each month as cash income for living expenses—without liquidating stocks in the portfolio and destroying the forest that they depend on to live.

Correct application of the covered call technique is the vehicle by which stocks are converted to cash flow generating assets.

OPTIONS ARE NOT JUST AHIGH RISK/HIGH RETURN INSTRUMENT

Options are without doubt the most misunderstood, misrepresented, and poorly implemented financial tool in the world. When asked about options, most people (including those “in the know” like financial planners, stockbrokers, and accountants) will tell you that “they’re high-risk, high-return instruments.”

It is astonishing that even those who are financially educated seem unaware that options can be used to minimize or even eliminate risk in a stock portfolio. In fact, options were originally not devised for use as a speculative instrument. They were originally used in the agricultural industry to reduce risk by locking in future sales prices before harvest. Regardless of this original intent, options maintain the label of “high risk, high return.”

The high-risk, high-return label derives its origins from the speculative use of options. Speculators use options to bet on the direction of the markets for the potential of very high returns. However, with these high returns come very high risk, and the vast majority of speculators fail over the long term. If you ever attempt to speculate with options, there is a very high chance that you, too, will be unsuccessful over the long term.

What evidence do we have that the vast majority of speculators fail over the long term? Well, if just 10 percent of the world’s speculators were making regular 50-100 percent returns per trade over the long term (as is the goal of a speculator), then the world would be full of multi, multimillionaires who made overnight fortunes trading options. Clearly, this is not the reality. However, this get-rich-quick ideal continues to be perpetuated by the endless hope of investors seeking a quick and easy solution to their financial woes.

Options markets are a zero-sum game. Someone wins only when someone else loses. If most speculators lose in the long run, who are the winners? Apart from the market makers and the small portion of speculators who win over the long term, money flows each and every month into the hands of option writers. Option writers are the people who are selling option contracts to the speculators.

What we want to teach you has nothing to do with the risky practice of speculating with options—this is not high-risk, high-return trading. In fact, covered calls are almost the complete opposite. In this book we show you a way to use options to make consistent, steady profits that you can rely on to pay your mortgage and put food on your table or to compound your investment capital through time into significant accumulations of wealth.

JOSEPH HOOPER AARON ZALEWSKI

CHAPTER 1

An Introduction to Options

MARKET BASICS

This section is written specifically for the stock market novice. It is aimed at those who have never bought a stock before or those who have very little understanding of the most basic functions of stock and option markets.

What Is the Stock Market?

From the perspective of a private investor, the stock market provides a venue for the buying and selling of stock of publicly listed companies. If you want to buy fruit, you go to the fruit market. If you want to buy stocks, you buy them through the stock market—it is as simple as that. Other common terms for the stock market include:

• Share market

• Equity market

• Simply “the market”

From the perspective of a company, listing on the stock market provides access to a large amount of investment capital that would not otherwise be available to an unlisted company. The market provides companies with the ability to seek investment funds from retail investors as well as institutional investors (fund managers, banks, etc.) who invest on behalf of others. Access to this public market capital enables a listed company to significantly extend its potential funding base upon which it can expand and grow its business in the future.

What Is a Share?

A share represents a portion of ownership of a company. Public companies are very large and, in most instances, are not owned by just one person or entity. Many thousands of different people or entities own stock in large listed public companies.

A share literally entitles its owner to a portion of a company’s earnings (as dividends) and a claim on the company’s assets in the event of bankruptcy (priority given to creditors). Through the election of company directors, stockowners are also entitled to participate in deciding the future direction of the company.

Most adults are already stockowners. Some of these stockowners are active investors who buy and sell stocks based on their own research or on the advice of their peers or professional advisers such as a stockbroker. Other stockowners gain exposure to the stock market through mutual funds where money is pooled and invested by a professional fund manager.

How Are Stocks Bought and Sold on the Stock Market?

Think of the stock market like a fruit market. Let’s assume you want to buy 10 bananas. You need to go to the fruit market and see who is selling bananas and at what price. Store owners are entitled to sell their bananas at whatever price they see fit. Obviously they don’t want to make the price too high or their fruit won’t sell, or too low because then they are not making as much money as they could.

You find three different stores selling bananas:

Asking Price, 10 Bananas

Store 1$1.40Store 2$1.47Store 3$1.60

You obviously want to buy your bananas as cheaply as possible. If you think $1.40 is reasonable, you might simply buy them from store 1 at that price. If you are only prepared to pay $1.35, then you might “bid” to buy them at $1.35. The manager at store 1 may agree to this price as it’s not far away from his asking price. If you both agree on a price, the bananas will sell.

Buying stocks on the stock market works exactly the same way! Let’s assume you want to buy 100 shares of General Electric (GE). You look up the price at the stock market by calling your stockbroker (or going to your broker’s online site). You are presented with the market for GE stock. It looks Table 1.1.

TABLE 1.1 The Market for GE Stock

If you want to buy 100 shares, you need to buy them by reaching an agreement on price from someone who wants to sell them. The sellers put into the market how many shares they want to sell and at what price (the “ask” price). You obviously want to buy the stock as cheaply as possible, so the seller asking the lowest price is always at the top of the list. He or she is offering 5,000 shares for sale at a price of $25.20.

You now have two options:

1. If you think $25.20 is a reasonable price, you can simply put in a bid to buy 100 shares of GE at $25.20 and your order will be filled.

2. If you think $25.20 is not a reasonable price, you can put in a bid for less.

Let’s assume you think $25.10 is a reasonable price. You enter this bid price into the market and the market will then look like Table 1.2. Your bid is now at the top of the column because you are the current highest bidder. If the seller at $25.20 (or any other seller) thinks that $25.10 is a reasonable price, he or she may change the order to $25.10 and the stock will trade. Or a new seller might come into the market enticed by your bid of $25.10 and your stock may trade.

What Is a Stock Code or Symbol?

All stocks that trade on public markets are represented by an individual stock code or symbol. No two stocks have the same stock code.

TABLE 1.2 Entering a Bid into the Market

While these terms can be used interchangeably, in the United States, the term symbol is used. U.S. stock symbols consist of one letter to five letters. For example, Citigroup is represented by the symbol C, Wal-Mart is represented by the symbol WMT, and Shire Pharmaceuticals is represented by the symbol SHPGY.

Option contracts in the United States are also represented by symbols/ tickers, which are generally five letters long. As with stocks, no two option contracts have the same symbol.

What Makes Stock Prices Go Up and Down?

Many factors influence the price at which a company’s stock trades, the most important factor being a company’s future earnings. Various fundamental factors combine to influence a company’s future earnings. You will become very familiar with fundamental factors as they are of particular interest to financial analysts and also gain significant exposure in the financial press. Common fundamental factors that affect the future earnings potential of a company include:

• Company-related issues such as increases or decreases in sales, increases or decreases in the cost of doing business, and changes in asset position, management team, business model, or perceived business risk.

• Industry-related issues such as the financial performance of competitors or introduction of significant legislation.

• Economic-related issues such as the economic growth rate of economies in which the business operates, currency fluctuations, and interest rate or inflation rate changes.

If a fundamental factor changes and causes the market to think that a company’s future earnings will be higher (lower) than previously expected, the stock price will adjust upward (downward) accordingly.

Other influences on stock prices that you should be aware of are technical factors. Technical analysis is the study of stock price charts through time. There are many investors and traders in the financial markets who make buy and sell decisions based solely on technical analysis because they believe that all fundamental factors are represented in the price charts they analyze.

We discuss both fundamental and technical factors in more depth later in this book.

What Is a Stockbroker?

Stockbrokers provide access to the stock market by entering buy and sell orders into the market on behalf of investors. Stockbrokers also hold accounts on behalf of investors where electronic records of stocks, options, and cash held are kept.

A brokerage account is just like a bank account except it holds stocks and options as well as cash. To set up a brokerage account, contact a broker (via phone or online), fill out the paperwork, and deposit money into your account. For the type of investing you are going to be doing, it is best to use a discount broker with the lowest possible transaction costs and fast executions.

Do not use a boutique broker (one who provides advice), even if you currently use one. They are expensive and, from this point on, you will not need their advice. You will make your own decisions and the returns you will generate may be many times what the best broker can do for you in the best year!

The brokerage industry is constantly evolving with new online players entering the market and existing brokerage houses regularly making changes to trading platforms and commission structures. The current industry best brokers for using the covered call technique can be found at www.compoundstockearnings.com/brokers. We strongly advise you to use one of these recommended brokers because trading platforms and transaction costs have a very dramatic effect on profitability.

What Are the Dow Jones Industrial Average, S&P 500, and NASDAQ?

The Dow Jones Industrial Average (the Dow), S&P 500, and NASDAQ are stock market indexes. A stock market index is used to represent the performance of a group of stocks rather than just a single stock. Apart from some exceptions (such as the Dow), indexes are generally constructed on a market value weighted basis. Consequently, the movements of larger companies have a greater impact on the performance of the index than do movements of smaller companies.

Some of the world’s most significant stock market indexes are listed in Table 1.3.

TABLE 1.3 Major Stock Market Indexes

Index NameMarketCompositionDow Jones Industrial (Dow)U.S.—NYSE30 stocks on New York Stock Exchange (NYSE)NASDAQ CompositeU.S.—NASDAQAll NASDAQ stocks; heavy in technologyS&P/ASX 200Australia200 largest and most liquid companiesFinancial Times Stock Exchange (FTSE)London100 largest companies; often called “Footsie”DAXGermany30 major companiesHang SengHong Kong33 largest companiesNikkeiTokyo225 largest companies

OPTIONS BASICS

What Are Options and How Do They Trade?

An option is a financial instrument and contract. An option gives the holder the right, but not the obligation, to buy or sell a financial asset at a certain price up to a certain date. An important distinction is “the right, but not the obligation.” The holder of the option does not have to exercise the right under the contract if it is not in his or her favor to do so.

Options (like futures) are known as derivative securities simply because their value is derived from the value of other more basic variables. For example, an IBM stock option is a derivative security because its value depends on the price of IBM stock. The derivative asset is also referred to as the underlying asset. In this case, the underlying asset is IBM stock.

Options are available on many financial assets including stocks, futures, and commodities. Most options are exchange traded, meaning they are traded on public markets, just like stocks are traded on stock exchanges.

There are two basic types of stock options:

1. A call option gives the holder the right, but not the obligation, to buy a stock at a certain price up to a certain date. Call options are used by speculators who expect an increase in the price of the underlying asset.

2. A put option gives the holder the right, but not the obligation, to sell a stock at a certain price up to a certain date. Put options are used by speculators who expect a decrease in the price of the underlying asset.

The covered call technique involves the use of call options only.

Options trade exactly the same way that stocks do. There are investors who want to buy options and there are investors who want to sell, or write, options. When these two investors reach an agreement on price, the contract trades. This trade happens in exactly the same way as previously described in the section on “how stocks are bought and sold on the stock market.”

All exchange-traded options have certain standard characteristics. Take this description of a contract as an example:

General Electric September 2005 $30.00 Call Option

Company nameAll exchange-traded options relate to a specific publicly listed company (or financial asset). In this case the contract relates to stock in General Electric (GE).Expiration dateAll options have an expiration date. In this case the option expires in September 2005.Strike or exercise priceAll options have a specific strike or exercise price. These two terms are used interchangeably. If you own this contract you have the right to buy GE stock at a price of $30.00.TypeAll options are either a call option or a put option. A call option provides the right to buy the stock. A put option provides the right to sell the stock. This contract is a call option.

If you owned the GE September 2005 $30.00 call option, you would have the right, but not the obligation, to buy GE stock at $30.00 per share up to the expiration date of September 2005.

Unlike stocks, options are referred to as contracts. In the United States, a standard contract relates to 100 shares in the underlying stock—this number changes depending on which country the option is listed in. Thus, if you buy four GE September 2005 $30 calls, you own four contracts. Each contract relates to 100 shares, so in this instance, you own the right to buy 400 shares.

What Basic Options Terminology Do You Need to Know?

Long and Short Positions An investor who has an overall buy position in a stock or option contract is said to be long. If you currently do not own GE stock and you purchase 500 GE shares, you are long 500 GE shares. If you purchase four GE September 2005 $30 calls and have no existing position in that contract, you are long four GE September 2005 $30 calls.

Conversely, an investor who has an overall sell position in an option contract is said to be short. If you currently do not own GE stock and you sell 400 GE shares, you are short 400 shares. If you sell three GE September 2005 $30 calls and have no existing position in that contract, you are said to be short three September 2005 $30 calls.

Table 1.4 shows each position classified as either long or short. It assumes that the investor has no existing position in any stock or option contract.

Opening and Closing Transactions An opening transaction is one where an option buyer or seller establishes a new position or increases an existing position as either a buyer or a seller. For example, if John buys one GE September 2005 $30 call, he is said to be “buying to open”—he has opened a new position. John may also elect to sell one GE September 2005 $30 call. In this case he would be “selling to open” if he was not already long in the identical contract. The effect of an opening transaction is that the number of contracts the investor is exposed to is increased.

TABLE 1.4 Comparison of Long and Short Positions

PositionLongShortBuy 300 GE sharesXSell 12 WMT callsXBuy 4 HD callsXBuy 8 JPM callsXSell 1 CD callX

A closing transaction is one where an option buyer makes an offsetting sale of an identical option or an option seller makes an offsetting purchase of an identical option. For example, if John is long one GE September 2005 $30 call and then sells one GE September 2005 $30 call, he would be “selling to close” because he has now closed out his position in that option contract and has no further rights or obligations under the contract. The effect of a closing transaction is that the number of contracts the investor is exposed to is decreased.

Alternatively, if John holds a short position of one GE September 2005 $30 call and then buys one GE September 2005 $30 call, he would likewise be “buying to close” because he has now closed out his position in that option contract and has no further rights or obligations under the contract. Again, the effect of a closing transaction is that the number of contracts the investor is exposed to is decreased.

Table 1.5 shows transactions categorized as either an opening or closing.

The important concept to understand is that an option buyer or seller can, at any time, close an open position by performing an equal and opposite transaction with the identical contract. Whether the transaction is closed for a profit or loss depends on the option’s price at the time that the closing transaction is executed. This action is very similar to closing a traditional stock investment—the investor can sell the stock and close the position at any time, but whether the stock can be sold for a profit or loss depends on the current market price at the time.

TABLE 1.5 Classification of Transactions

In the Money, Out of the Money, and At the Money Option market participants have coined the phrases in, out, and at the money to describe an option’s strike price in relation to the stock price.

An in-the-money option is one that has intrinsic value, where the owner of the option stands to profit by exercising his or her right under the contract. For a call option to be in the money, the stock price must be higher than the strike price. For example, a $15.00 call option is in the money when the stock price is greater than $15.00.

An out-of-the-money option is one that has no intrinsic value, where the owner of the option does not stand to profit by exercising his or her right under the contract. For a call option to be out of the money, the stock price must be lower than the strike price. For example, a $15.00 call option is out of the money when the stock price is below $15.00.

An at-the-money option is one where the stock price is trading at or very close to the exercise price. For example, a $15.00 call option would be considered at the money if the stock price was $15.00. In practical terms, market participants also describe an option as at the money when the stock price is close to the exercise price of the option. So, if an option’s strike price was $15.00 and the stock price was $14.80 to $15.20, it would be deemed as being at the money.

Table 1.6 shows options classified as being either in, at, or out of the money.

Physical Settlement Versus Cash Settlement There are two types of settlement styles for exchange-traded options: physical settlement and cash settlement. Physical-settlement options give the owner the right to receive physical delivery of the underlying asset when the option is exercised.

TABLE 1.6 Classification as In, At, or Out of the Money

Cash-settlement options give the owner the right to receive a cash payment based on the difference between the underlying asset price at the time of the option’s exercise and the exercise price of the option. The majority of stock options are physically settled while index options are cash settled.

American Versus European Expiration An American-style option may be exercised at any time prior to its expiration. A European-style option may be exercised only on its expiration date. The majority of stock options traded on U.S. and international options exchanges are American-style options. Our covered call technique involves the use of American-style options only.

Option Expiration Dates In the U.S. market, virtually all standardized option contracts expire on the third Friday of each month; they do not expire on the last day of the month. For example, if you hold a November option contract, this contract will expire on the third Friday of November, not at the end of November.

The Options Clearing Corporation The Options Clearing Corporation (OCC) guarantees that all market participants fulfill their obligations under the terms of options contracts. This is a very important function of an options market, particularly in terms of guaranteeing that options writers are capable of fulfilling their potentially large exposures.

Apart from keeping a record of all short and long positions, the OCC ensures that when purchasing an option the buyer must pay for it in full and the writer of an option must maintain an adequately funded margin account to cover his or her exposure at all times.

The clearinghouse allows the options market to function. Without it, the risk of counterparties defaulting on their obligations under an option contract would stifle the market.

Standardized Options and Option Chain Exchange-traded options are almost always standardized. Standardized options have set parameters in terms of the amount of an underlying asset a contract relates to, the expiration date, the exercise price, the multiplier, and the option style. Investors cannot alter the standardized characteristics of an exchange-traded option to suit their own needs—they must work within the standardized parameters provided by the options exchange. The most important function of standardization is to assist in the formation of liquid secondary markets where buyers of options can close out positions by selling an identical contract and sellers/writers can close out positions by buying an identical contract.

An option chain is a list of all standardized options available for a particular stock or index. Table 1.7 shows an option chain for the U.S.-listed banking group JP Morgan. Take a moment to study it and note the different strike prices and expiration dates available.

If you wanted to buy or sell a call option on JP Morgan, you would have to select an option contract from this option chain. You are not able to select contract specifications that do not appear in the standardized option chain. Note that for simplicity only call options appear on this option chain; the same option chain is also available for put options.

How Do Speculators Use Options to Trade the Market?

While we don’t use options to speculate on the future direction of a stock or market, many investors do use options for this purpose. It is essential that you understand how a speculative trade works in order for you to understand options markets.

Example of Using a Call Option to Speculate GE stock is currently trading at $30.00. John thinks GE stock is going to go up in the next three months. It’s now June, so John decides to buy a September $30.00 call option (note that he does not have to choose a strike price equal to the current stock price). John now has the right, but not the obligation, to buy GE stock at a price of $30.00 up to September. For this right John pays the premium of $1.00 per share. The premium is the price the option buyer pays to the option seller.

So let’s assume John’s hunch is right. It’s now July and GE stock is $35.00. John has the right to buy GE stock for only $30.00. He can exercise this right, buy the stock at $30.00, and immediately sell it in the market for $35.00 (the current stock price). John has paid a premium of $1.00 per share for this right. His profit appears as follows:

TABLE 1.7 JP Morgan Option Chain Example—Stock Price, $39.38

So what would have happened if John’s hunch were wrong and GE stock actually fell? John has the right, but not the obligation, to buy GE stock at $30.00. If the stock is less than $30.00, he would not exercise this right and would just let the option expire. If this were the case, he would lose the $1.00 premium he paid for the contract. It is important to realize that this $1.00 is the most John could possibly lose on this trade.

The maximum loss of an option buyer is the premium paid (the cost of the option).

Premium: The price of an option; the amount of money the buyer pays for the rights and the seller receives for the obligations granted by the contract. Expressed on a per share basis.

Example of Using a Put Option to Speculate A put option works very similarly to a call option; however, investors buy a put option when they think the price of a stock is going to fall. Let’s look at an example.

It’s now September and GE is trading at $35.00. John thinks that the price of GE stock is going to fall. So he decides to buy a December $35.00 put option. He now has the right, but not the obligation, to sell GE stock at a price of $35.00 up to December. For this right John pays, for example, $1.00 per share.

The price of GE stock then falls to $30.00 per share. John has the right to sell GE stock at $35.00. He would, therefore, go into the market and buy GE stock for $30.00 and then exercise his right to sell GE stock at $35.00. His profit would look like this:

So what would have happened if John’s hunch were wrong and GE stock actually rose? John has the right, but not the obligation, to sell GE stock at $35.00. If the stock is more than $35.00, he would not take up this right to sell and would just let the option expire. If this were the case, he would lose the $1.00 he paid for the contract. It is important to realize that this $1.00 is the most John could possibly lose on this trade.

Again, the maximum loss of an option buyer is the premium paid (the cost of the option).

Options Trading in the Real World Now you understand the rationale and logic behind an options trade, but trading in the real world is a little different!

In the real world, speculators very rarely exercise their option contracts in order to take profits from a trade. Take the first example where John has the right to buy GE stock at $30.00 and the stock is trading at $35.00. If John wants to realize a profit on this trade, it is highly unlikely that he would exercise this option. It is more profitable for John to just sell his call option to someone else in the market (sell to close).

Remember, John paid $1.00 per share for the right to buy GE stock at $30.00. If GE stock quickly jumped up to $35.00, he would actually be able to sell his call option for around $6.00. This $6.00 market value comprises $5.00 exercisable value and $1.00 of remaining time value. Both exercisable (intrinsic) value and time value are discussed in detail later in “How Are Option Prices Determined?”

John’s profit would look like this:

So John would make $5.00 per share by selling the call option, compared to only $4.00 per share if he exercised the call option, because exercising options results in a loss of time value (discussed in “How Are Option Prices Determined?”). By exercising the option, John will realize the $5.00 exercisable value in the contract ($35.00 stock price minus $30.00 strike price), but will forgo the remaining time value in the contract ($1.00).

Time Value: The portion of an option’s price that exceeds the exercisable value.

Due to this loss of time value, option traders very rarely exercise options in order to take profits from a trade! Options are traded just like stocks, and profits and losses are made, for the most part, by buying and selling the option itself, not by exercising it. So, it is important to remember:

Option traders very rarely exercise their options more than two weeks before expiration. In practicality, the vast, vast majority of option contracts are exercised on the third Friday of expiration. Exercising options early results in a loss of time value to the option buyer. Instead, option traders simply buy and sell the option contract just like buying and selling stocks.

Why Speculate with an Option Instead of a Stock?

Why speculate with an option instead of a stock? The simple answer is leverage