Options Education Series - Part 1 : Three Ways to Capitalize On Options

You will reduce your risk if you take your 500 shares of ABC stock, sell them, and then buy five ABC call options that are a few strike prices in-the-money.

Example:



If ABC is at $60.00/ share, and you pull up the option chain and look at the 2009 January calls, you might see these call options available:



2009 January 60 calls trading at $9.00    (These are at-the-money)


2009 January 55 calls trading at $12.00  (These are one strike price in-the-money)

2009 January 50 calls trading at $15.00  (These are two strike prices in-the-money)

2009 January 45 calls trading at $18.50  (These are three strike prices in-the-money)



It makes more sense to buy five of the 2009 January 45 calls at $18.50 (for $9,250.00)instead of buying 500 shares of ABC stock at $60.00 (for $30,000.00).  THEN, put the remaining $20,750.00 in a money market account and earn 5%.




The intrinsic value of the option is $15.00 (because the stock price of $60.00 minus the strike price of $45.00 = $15.00) and the extrinsic value of the call option is the remaining $3.50 (because the call costs $18.50 minus $15.00 intrinsic value = $3.50).  That means that over the life of the call option (especially in the last few months leading up to the January 2009 expiration), that $3.50 extrinsic value (aka "time value") deteriorates.  That means that if your ABC stock trades flat at $60.00 for the next 16 months, the option would lose $3.50 and move to $15.00.




Keep in mind that the $3.50 loss (assuming that you actually held on for the next 16 months) is a loss of $1,750.00.  But since you put the rest in a risk-free money market account, you earned $1,383.33 interest.  So the loss is reduced to $366.67.  (And that would equate to 73 cents of the call option instead of $3.50.)



Now - what are you getting in return for your willingness to lose 73 cents over the course of 16 months on a $60.00 stock (which really only equates to 1.21%?)



#1) You know that your absolute MAXIMUM downside risk is the $18.50 (or $9,250.00) that you invested in the call option, instead of the $60.00 (or $30,000.00) on the stock which likely wouldn't lose all of its value, but as we know, a loss of anything between one cent and $30,000.00 is possible.



There are many benefits here that one wouldn't consider at first.  One of them is the psychological benefit.  I mean, you would be a lot less worried about the stock market crashing, for one. That would allow you to feel more confident when buying when people are fearful.  That means that you would be buying when things are down.




(Also, remember that you should usually play both sides of the market.  So you can also buy in-the-money put options to bet on the downside.  That means if the stock is at $60.00, and you were betting that it would trade lower, you would buy the 2009 January 75 puts.)



#2) If your stock moves higher, you are making almost the same amount that you would have made on the stock.




#3) If your stock moves lower, you are probably going to lose much less than you would have on the stock.  (A very basic hypothetical example is that if the stock trades up 10 points, you will probably make 9 - 9.5 points, but if the stock trades down 10 points, you will probably lose about 7 points.)  So you see, the downside vs. upside ratio is less than par.

You only get the downside vs. upside ratio benefit if you do two important things:



1) Buy the options that are in-the-money by a few strike prices.

2) Buy an option that has a long time until expiration day like the example that we used, preferably at least one year.  The ultimate goal is to be out of the position at least three months before the option expires.


Source:
          iStock Analyst