Options are a
strategic alternative

A seminar this week takes the
mystery out of puts and calls

By Dave Segal

To many investors, options trading conjures up the image of fast money, high risk and stomach-churning volatility.

But it doesn't have to be just for the bold and adventurous, according to Greg Stevens, staff instructor for The Options Institute, the educational arm of the Chicago Board Options Exchange.

Stevens, who will team with Charles Schwab & Co.'s Greg Wolff in conducting two options seminars Wednesday at the Hawaii Prince Hotel, said options can be suitable for conservative and defensive investors, too.

"There are strategies out there other than speculative strategies using options," Stevens said earlier this week in a telephone interview. "There are strategies of buying protective puts and writing covered calls that are very conservative strategies. One (covered calls) is generating income on an existing position and one (puts) is reducing the risk of stock ownership."

Generally speaking, options give a buyer the right to purchase stock at a predetermined price, called the strike price, until the expiration date of the option. The buyer can purchase a call option contract, anticipating the stock price will rise, or can buy a put option contract, hoping the stock price will fall. The life of the options can be as short as a few days or, in the case of LEAPS (Long-Term Equity Anticipation Securities), as long as 2 1/2 years.

Ultimately, one of three things will happen: 1) The options will expire worthless; 2) the investor will exercise the options and actually buy the stock or; 3) the investor will close out his position by selling the options at either a price higher or lower than he paid in the first place.

"There are no published numbers of what percentage of people make money or what percentage of people lose money," Stevens said. "What most people think is that the majority of options expire and they lose all their money. That's not necessarily the case."

Stevens said data since 1973, when the Options Clearing Corp. was founded, as well as information received from the CBOE, reveal that about 30 percent of options expire, 10 percent are exercised and the remaining 60 percent are closed out prior to expiration.

Despite public perception to the contrary, Stevens doesn't think it's any riskier to buy an option than to buy a stock.

"Both require a certain level of analysis," he said. "Any time you go into investments without proper research of what you're looking to do, both can be very risky. There are different benefits and risks to doing both."

Among the benefits of being a stockholder, he said, are stock ownership, the right to receive dividends and the right to vote on shareholder issues.

"The tradeoff (of stock ownership) is that the risk is substantial," he said. "If you buy 100 shares of XYZ stock at, say $40 a share, your risk is $4,000."

In the case of options, an investor has additional leverage because he can control more shares with less money. The risk, though, is that since the options are only good for a certain length of time, they may expire worthless or the buyer may have to sell the option contract for less than the purchase price.

Since each option contract represents 100 shares of stock, an investor could buy one XYZ option contract with a $40 strike price and control $4,000 worth of stock. The ability to control the $4,000 worth of stock conceivably could cost the investor, let's say, just $500 if the strike call price is $5 (multiplied by the 100 shares of stock that option contracts represent). Generally speaking, the more time remaining in the life of the option, the costlier it is to purchase.

"Options are an expiring asset and you need to have a more defined forecast when purchasing them," Stevens said.

In other words, if an options investor guesses the wrong direction a stock is heading, the investor could end up losing all his investment because there might not be enough time remaining for the stock to recover and make the option profitable. For those investing in stocks, time generally is on the buyer's side unless something is fundamentally wrong with the company, the company declares bankruptcy or the investor needs his money sooner than anticipated.

In Wednesday's seminars, the first session, scheduled from 1 to 4:45 p.m., will deal with the basics and will be geared toward investors with limited experience. It will cover trading terms, options pricing and trading strategies.

The second seminar, scheduled from 5:30 to 9:30 p.m., is designed for investors with options trading experience. It will cover options pricing volatility, how to leverage LEAPS in trading strategy and lessons learned from an options trading case study.

The cost is $75 per session. Reservations can be made by calling (888) 396-5262 by Tuesday. Walkups on Wednesday will be accepted on a space-available basis.

"The reason I believe there's not more people in options is because people are not aware of how the product can help them," Stevens said. "There's simply a need for education. Not only don't people understand how they can use the product, but they also perceive that options are risky."

Dwight Melton, a member of the National Association of Investors Corp. Aloha Hawaii chapter, a nonprofit investment education organization, is a proponent of covered calls.

"I've been writing covered calls for the past six years," Melton said. "Covered call writing is more conservative than the outright purchase of common stock because the investor's downside risk is reduced by the amount of the premium received for selling the call. As a matter of fact, I wouldn't even buy a stock if it doesn't trade options. Writing covered calls are low enough in risk that it is allowed in an IRA brokerage account."

In this options strategy, a covered writer must own the underlying common stock but is willing to give up price increases in excess of the option strike price in return for the premium.

Stevens stressed that it's important for investors to do their homework in options just like they would for other investments.

"It takes a little bit of work and knowledge to trade contracts," he said. "Hopefully, what we'll impart to the individuals at the seminars is that trading options is different than stock trading and it does require a forecast and some knowledge."

Getting technical

What: Options seminars

Who: Charles Schwab & Co., Chicago Board Options Exchange

When: Wednesday, 1 to 4:45 p.m., "Options Fundamentals;" 5:30 to 9:30 p.m., "Intermediate options"

Where: Hawaii Prince Hotel, Mauna Kea Ballroom

Cost: $75 per seminar

Information: (888) 396-5262.

Deadline: Tuesday; walkups accepted Wednesday on space-available basis


How to buy an option

Let's say that Joe Investor thinks Widgets Inc., currently trading at $40, is going to hit $50 at some point during the next six months. Joe can't afford to buy 100 shares of the $40 stock because he doesn't have $4,000. However, he knows that for a fraction of the cost he can buy a call option that would allow him to participate in the rise of the stock. Joe, who has only $1,000 to spend, looks at the options listings for Widgets Inc. in the Wall Street Journal to find the price for six-month, $40 strike price call options. He sees that option contracts for the six-month $40 strike price are selling at $5 each. Since each option contract represents 100 shares, Joe could buy one contract for $500 or two contracts for the $1,000 that he has available to spend. He now controls 200 shares, or $8,000 worth of stock. Generally speaking, the option tracks the stock so the value of the option rises if the stock rises. However, as the option's expiration nears, it loses value.

If the stock approaches $50 during that six-month period, Joe will make a profit on his investment. For example, if his options rise from the $5 purchase price to $7, he makes $200 for each of his two options contracts, or $400. But if the stock -- and hence the option -- decline in value, Joe could lose some or all of his investment.

In addition, if Joe now has extra money to spend, he can convert as many of the options into stock as he can afford. If the stock now is at $50, Joe has the right with each option contract to buy 100 shares at $40 each.

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