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All About Options [Secure eReader]
eBook by Thomas A. McCafferty

eBook Category: Personal Finance
eBook Description: To minimize risk and greatly increase return, lightning-fast options trading instincts are critical. All About Options, Second Edition is the ideal first step to developing these instincts. With its in-depth coverage of the basics of options and option trading, this new edition is perfect for beginners as well as traders going to the next level. It provides: Facts and figures updated from the first edition, with more on stock options; Up-to-the-minute material on changes in the marketplace and technology; In-depth explanations of options trading strategies from basic to complex. Knowledgeable options trading is a key element of any effective strategy. All About options is the clearest, easiest-to-follow guideBook today on the pros, cons, risks, and rewards of using options.

eBook Publisher: McGraw-Hill Companies, Published: 2002
Fictionwise Release Date: July 2002




PREFACE

First, we need to address the following questions--

  • What Are Options?

  • Do They Have Economic Value?

  • How Should an Investor Use Stock Options and Options-on-Futures?

  • What Are the Pros and Cons, Risks and Rewards?

  • Is Option Trading Gambling?

Options, in general, are the legal rights, acquired for a consideration, to buy or sell something at a predetermined price by a certain time in the future. Options are very common in real estate, for example. Developers will take options on certain pieces of property as they plan projects. It gives them time to obtain zoning approvals and capital for development. The option locks in the price and buys time.

Real estate and most other options are negotiated from scratch by the two, or more, parties involved. The buyer and seller need to agree on all the terms or specifications, not to mention price. Reaching an agreement may take anywhere from a few hours to several months. Negotiations can break down, resulting in no agreement or option.

There is another type of option. It is called an exchange-traded option and is the province of this book. This type of option differs from the other in that all the specifications are prearranged, except price. For stocks, options generally "cover" 100 shares of the underlying stock; options-on-futures are on the underlying futures contract. All the other specifications -- delivery date, place and type of delivery, quality, etc. -- are clearly defined. The only variables are the number of options to be bought or sold and the price.

Since buyers or sellers decide for themselves on quantity, the only thing left to negotiate is price. It is this characteristic of uniformity that makes the stock and futures exchanges possible. The exchanges, in turn, render society in general, and the business world in particular, a very important economic service -- the discovery of price. Trading in options and the underlying stocks or futures contracts tells users, planners, reporters, economists, speculators, investors, government officials, and anyone else interested, the current value of a company's stock or a commodity, along with projected price trends into the future.

If you are a user or processor of soybeans, copper, money, or any one of the over 60 options-on-futures traded in the United States, you can easily check the futures market to obtain the current price and get a good insight into what prices are expected to be 3, 6, or 12 months from now. A look at any of the thousands of stock option prices tells you what savvy traders think about the prospects of individual stocks. Or you might study one of the many composite indexes of stocks, commodities, utilities, foreign currencies, etc. (or the options on these indexes), to get a feel for the price direction of an entire market.

Another possibility might be that your analysis indicates you are facing some serious financial risks. Options could provide some relief. This is the second very important function of the options markets. Coupled with risk management is the ease and convenience of buying and selling options.

Let me give you an example. You own a quantity of something. It could be an agricultural product (grains, livestock) or a financial entity (a stock portfolio, Treasury bonds). Analysis of the price trend indicates that the commodity you own could lose value over the next 6 months. You don't want to or can't sell the commodity until then. What do you do? You can offset the risk of ownership by taking a short position in an option. You freeze the price through the purchase of the proper option. This is known as hedging and will be discussed in detail in the chapter on strategies.

The important point is that the options markets can be used to pass the risk of ownership of stocks and commodities to someone, the speculator, who wants to accept the risk. The speculator's objective is to make money from the acceptance of the risk. The beauty of using exchange-traded options is the ease with which the transfer can be accomplished.

For example, you don't have to go out and find people to accept the risk. They are immediately available at the exchanges. When you're ready to close out your position, you can do it with a single phone call to your broker.

If you are dealing with a foreign currency or foreign financial instrument, you do not have to worry about setting up an asset custodial relationship in the foreign country. Nor is there any problem with transferring money to another corner of the world or finding an English speaking broker or currency conversion. Additionally, there are ways, which I'll discuss later in this book, for trading these markets 24 hours a day. This can become important when major economic or political events occur while U.S. exchanges are closed. The fall of the Berlin Wall and the outbreak of Desert Storm come to mind as times when this facility might be utilized.

I would be remiss in my discussion of the benefits of options if I didn't mention how they can improve the efficiency of your use of capital. Buying an option on any underlying entity can be done for a fraction of the cost of obtaining outright ownership of the entity. Keep in mind, when you buy an option, that you are only acquiring the right to assume ownership before a given date at a predetermined price. You don't own the entity.

By the same token, when you're ready to exit your option positions, it is nothing like selling an entity you actually own and possess. There are no shares to sign and deliver (stocks). Nor do you have to truck your commodity to the elevator (grains) or stockyard (livestock) or remove it from a safety deposit box and have it assayed (precious metals). You avoid all quality and quantity confrontations that can occur when commodities are handled, rehandled, stored, and shipped. It is not uncommon for farmers to sell their crops right out of the field and then buy options to replace the actual grain in order to partake of the seasonal price rises that normally occur after harvest. Gone are the worries of spoilage, cracked kernels, and rodents -- not to mention the hassle of handling and rehandling the crop and trucking it to the elevator.

LIMITED RISK AND UNLIMITED REWARD

So far, I have only briefly alluded to speculators, the people who make the whole system work. Speculators assume all the risk others wish to avoid. Most of you readers will fall into this category.

What motivates speculators to buy options is that they know in advance to the penny what their financial risk will be -- but their potential profit is theoretically unlimited. They risk the cost of the option, known as the premium, and the transaction costs, which are brokerage commissions and fees. The reward depends on how much value the underlying entities gain before the speculators take their profits.

A speculator could conceivably buy an option for $300 and sell it for $3,000 or $30,000 within 30 days. This is certainly possible and has happened, although it is not normally the case in the options markets. The normal course of business is for options to expire worthless. In other words, the speculator invests $300 and loses $300. Experienced option traders usually offset their positions before the options expire worthless. The traders will invest $300 and close the position when it has lost $100 or $150. They'll continue to do this until they choose some winners. I'll talk about this in detail in the discussion on how to use the law of probability to become a net winner as an option trader.

Even the concept of unlimited profit potential needs some explanation. Theoretically, options have unlimited profit potential -- the emphasis here being on the word "theoretically." But prices for stocks or commodity futures normally do not rise or fall unlimited amounts. At some price, they become either too expensive or too cheap. For example, during the Great Depression, the price of corn fell so low that corn was cheaper to burn than coal. And that's what some farm families did. On the other end of the spectrum, when corn gets more expensive than wheat, livestock producers feed their animals wheat. The demand for and the price of corn eventually return to more reasonable ranges. The same is true for stocks. If the price of a company's stock drops below the liquidation value of that company's assets, what will happen? Or what will happen if the price of a stock rises so high no one can afford it? The answer is the same in both cases: The market adjusts the price accordingly.

Additionally, there is the profit taking motive to factor into the supply-demand equation governing the price of stocks or commodities. Investors who got in early, on a bull or bear move, will take their profit at some point. Eventually, the profit takers turn the market around.

What option traders have going for them is predefined risk, rather than limited risk. On the profit side, they have the prospects of an excellent return, rather than unlimited profits. Experienced investors seek outstanding risk-to-reward ratios. If they can invest $500 with the potential of making $5,000 in a few weeks, or a 1:10 risk-to-reward ratio, they'll consider it.

Another reason for buying options that appeals to speculators is the staying power it gives them in adverse markets. Buying options-on-futures, unlike futures themselves, does not require margin money or a good-faith deposit. The risk is fixed, as previously stated, to the premium and transaction costs. If the markets move against your position, you can hold the option to expiration without having to put more money into the investment. With futures, traders have to replace any money lost when the market moves unfavorably. If you have a very strong conviction that the market being traded will eventually be profitable, an option, if it has enough time to expiration, provides the staying power to hang on to the position.

IS OPTION TRADING GAMBLING?

If investors do not do their homework, arbitrarily buy options, and do not closely follow the markets, you might as well consider what they're doing is gambling -- but wouldn't this be true for any investment?

Serious option traders use the law of probability to take advantage of the distortions in the supply-demand situations of stocks and/or commodity futures contracts that regularly occur. Experience, research, and even a little help from a good broker can put the statistical odds in your favor.

Trading options on stocks and/or futures is complex. Serious investors must invest in books, newsletters, seminars, software and other educational materials. Much time is required to master option trading -- but the potential rewards can make the effort a joy.

On the other hand, I have no intention of misleading you. Option trading, like trading in any other investment, entails substantial risk. Not every investor is suited for it because it is such a highly speculative venture.

Reading this book is a good start toward understanding options, but please consider it as only the beginning. When you're finished, you should have a solid overview of the subject and a good idea of where you need to turn next in your quest for success in the options markets.

Copyright © 1998 by Thomas McCafferty


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