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Chapter 1: Introduction to OptionsWhy Stock Options?
Most Americans are aware today of the unprecedented explosion that has taken place in stock investing and ownership over the past 10 years. Whether through their retirement plans at work or in their personal investment accounts at home, a rapidly growing number of American households now own stock in publicly traded companies. Also well documented is the fact that an increasing number of individual investors axe actively involved in making their own investment decisions, specifically in the area of buying and selling stock. Less widely known, however, is that alongside this escalating interest in personal investing and portfolio management is a growing curiosity about the potential benefits of stock-option trading.
In fact, evidence shows that the excitement of this new opportunity has led many new online traders to rush into trading with a get-rich-quick mentality. The attitude is "buy low, sell high." New traders are so eager to make money in the marketplace that they commit a majority of their capital to a position without taking the time to analyze the risk/reward profile. At this writing, all evidence indicates that the majority of all day traders are losing money. There are several reasons. First, most day traders do not fully understand risk management. Rather, their primary strategy is essentially based on hope. Second, they are committing too much capital to a position, and they are not treating trading as a business. Instead, they treat it as a lotto game. The California Lotto slogan rings so true with the day-trading herd: "You can't win if you don't play!" How many lotto winners do you know?
On the other hand, those who have been less quick to act (the cautious investors among us) have remained on the sidelines, reflecting on what they have heard concerning the inherent risks of option trading. Having read that options are primarily used for speculation and that most will expire as worthless, these investors turn their backs on options and on the potential that they have for enhancing their investment or trading performance. What we can see, then, is that although stock-option trading is steadily gaining legitimacy, many of today's newcomers-the enthusiastic and cautious alike-do not sufficiently understand stock options in order to use them effectively as components of an overall investment strategy.
As professional options traders, we have been buying and selling options for a living for many years. We understand the risks and rewards of options in a way that the individual investor might not, and from that standpoint, we believe that for both the enthusiastic and cautious investor, a sound education in stock-options trading is a necessary investment. From our vantage point, we get to see how investors are using (and, in some cases, abusing) stock options. In addition, options trading can be risky-especially for those who want to use options speculatively in order to create quick wealth. Yet, at the same time, we are more than familiar with the ways in which options can be used to preserve existing wealth and create predictable sources of income. How you use options is what matters. We would like to encourage the enthusiastic and hesitant investor alike to use this book in order to obtain the real facts about stock options. Our strong belief is that individual investors can and should learn how to use stock options intelligently and prudently-and in so doing, they will make themselves available to new horizons in trading and investing. Consider, after all, that although the consequences of an accident or equipment failure can be devastating, most of us drive cars anyway. We have decided that the benefits derived from driving are worth the risk. In both cases, we are all the more likely to benefit if we learn how to be good drivers and when to follow code. Options trading/investing is much the same.
History of OptionsThe Earliest History
The use of options in an attempt to ensure economic security or financial gain dates back in our history much farther than most people would expect. The first published account of options use was in Aristotle's Politics, published in 332 B.C. According to Aristotle, Thales, a fellow philosopher, was said to be the creator of options. Thales was not only a great philosopher but also a great astronomer and mathematician. In response to criticism that his profession had no merit, Thales used his ability to read the stars in order to forecast future weather patterns. His skill enabled him to predict a large olive harvest in the coming year.
Thales, however, had little money and was unable to secure the use of the olive presses for their full value, so he put deposits on all of the presses that existed for miles and miles. In doing so, he used a small amount of money to secure the right to use the presses come harvest season. When olive-picking time came around and the presses were in great demand, Thales was able to sell his options for a great deal more than he paid for them. Unknowingly, perhaps, Thales had created the first option contract. He purchased the right to use the presses, not the presses themselves. In doing so, he was able to use considerably less money than he would have if he purchased the presses themselves. Owning the right gave Thales the ability to use the presses during harvest time himself (or to sell his options when, due to the demand, they would be worth considerably more than when he entered the contract). The seller, on the other hand, was happy to sell the right to use the presses, because it ensured that the seller would receive income whether the harvest was successful or not. In securing a price for the presses, however, the seller gave up the right to charge the customers more for use of the presses during a record harvest. Thales' foresight enabled him to reap this benefit. Clearly, then, Thales was able to redeem philosophy and astronomy from any accusations that its practitioners had their heads in the clouds.
Options sprang up again during the tulip mania of 1636. Tulips were first imported into Europe from Turkey in the 1500s. These brightly colored flowers gained in popularity, and the demand increased for all types of bulbs. By the early 17th century, tulips had become a symbol of affluence; demand began to outweigh supply; and tulip bulb prices rose dramatically...