Posted by: Tyson Heyn | August 26, 2009

What can you do with stock options?

As mentioned yesterday, one of the key benefits of trading through stock options is your ability to control exactly how much risk you take as well as how quickly that risk is realized.

Options are to stocks as LEGO is to a pre-fabricated toy: you still can end up with the same result, but with the former, you have much greater control on the specifications of what you want.

Here are some real-world, everyday examples of how you can use options to meet your own requirements:

  • Insurance.  Suppose you were smart enough to buy 100 shares of Apple (AAPL) stock earlier in the year and have enjoyed a very nice gain.  You believe that the stock still has considerable upside going into the Christmas season, but you also know that there might be a few bumps along the road.  How can you continue to own the stock while protecting your gains?

    Stock only:  Set a sell order trailing stop for a few dollars below the current valuation.  So, for example, if the stock ($169 today) were to go below $165, the shares would automatically be sold in order to lock in the gains from the past few months.  With a trailing stop, if the stock headed to $179 without any major turbulence, the trailing stop would rise with the appreciated stock price to $175 and be triggered if AAPL then dropped below $175.

    The downside to this strategy is how to re-enter AAPL.  At what price?  Did you pick the correct bottom?  What if you buy in again at $160 and the stock just continues to drop?  This is where options can provide significantly improved cover.

    Stock with a purchased put:  A put is a guarantee that you can sell your stock at a pre-determined (“strike”) price on or before a pre-determined (“expiration”) date.  Most puts cover 100 shares of a stock.  Buying one put for AAPL with a strike price of $165 through September 19 costs $342.  That’s still less than the $400 you’d lose if AAPL dropped below $165.

    Stock with a purchased put and sold call:  If you don’t like the idea of paying $342 to insure your investment, there’s good news: financing is available.  You can sell a call and essentially cap the maximum reward you can realize on the stock by the expiration date.  The proceeds of the call help to finance the purchase of the put.  So, for instance, if you’re willing to limit your profit on AAPL stock to a $180 share price between now and September 19, you’ll earn a $159 credit towards the put protection being bought, bringing the net cost down to $183.  For reference, this sort of transaction is called a collar.

  • Leverage.  With stock, the percentage of profit made from a single position holds a 1:1 relationship to the share price.  In other words, if the Acme Inc. stock you own rises from $100 to $110, you’ll make a 10% profit.  The same goes for losses, as well.

    Some folks indulge margin from their stock broker in order to try to double returns.  Here, they literally borrow money (up to 100% the value of their portfolio) to buy even more of the stock.  Again, this is great if the stock price goes up–you now own twice as much stock for the same amount of capital–but if it goes down, all of the losses come out of your balance.  To me, this is high-risk and unnecessary.

    A much safer way, again, is with options.  With a small amount of money, you can position yourself to enjoy additional upside from a stock.  Your loss is never greater than the amount of money invested into the options, which is most often a very small fraction of the share price.  (Going back to AAPL, holding a call that is the equivalent to 100 shares of the stock at $165 costs merely $782.  Just remember that any value under $165 on the September 19 options expiration date becomes worthless.)  So, if the stock increased another $5 tomorrow, your call would be worth around $1,140.  Down $5 tomorrow?  About $502 in value.

  • Inversion.  Let’s say that you believe AAPL is about to tank, but you don’t want or aren’t able to short the stock directly.  Instead, you can buy puts–the guarantee that someone will buy your shares from you at a fixed price.  You don’t need to own any shares to benefit from this.  One September expiry put of AAPL with a strike price of $165 costs you $342.  If the stock dropped $5 tomorrow, the put that you purchased would be worth about $560.  The opposite holds true, as well: if the stock went up $5, the put’s value would fall to roughly $202.
  • Income Generation.  My favorite options strategy is this one: buying and selling puts and calls in order to generate income.  Here, you’re essentially calculating a range where a given stock should remain, and the longer the stock stays in the range, the more money you make.  The risk is controlled by how tight or loose a range you make: betting that AAPL will close between $165 and $170 on the September 19 options expiration date could yield you a 26% return while a range of $145-$190 nets you only about 5%.

    There are several different ways to configure this sort of trade, all of which I’ll get into in forthcoming posts.

So think of options as your LEGO set and think about what you’d want to build.  There are a lot of different elements available to spark your imagination and trading strategy, so stay tuned as we dive through several of the most successful ones.

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