Understanding Options

Understanding Options

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by Michael Sincere

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  • Illustrates profit and loss results for simple options and option spreads
  • Explains the Greeks and their importance
  • Outlines how options offer four ways to approach the market
  • Includes a step-by-step walk-through of placing an order
  • Overview

  • Illustrates profit and loss results for simple options and option spreads
  • Explains the Greeks and their importance
  • Outlines how options offer four ways to approach the market
  • Includes a step-by-step walk-through of placing an order
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    McGraw-Hill Education
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    By Michael Sincere


    Copyright © 2007 The McGraw-Hill Companies, Inc.
    All right reserved.

    ISBN: 978-0-07-170970-5

    Chapter One

    Welcome to the Options Market

    I'm delighted that you decided to join me as we learn more about options and options trading. If this is your first time, options might seem confusing, at least at first. Options can be deceiving, as if you are walking through quicksand. At the beginning, it seems straightforward and easy. But as you get in deeper, it can get murkier, and before long you find yourself sinking under the weight of options terminology.

    As you become more familiar with the strategies, it gets easier. But don't get me wrong. Learning about options is like learning a new language. The good news is that you don't need an advanced degree in mathematics to be a successful options trader. In fact, all you need is a computer and a calculator. If you need to do sophisticated calculations, most brokerage firms have software programs that can provide you with quick answers.

    As usual, the best way to learn is in small steps, which is exactly how I present the information. If you are like my speculator friends, you will want to jump right into options strategies. But I urge you to take the time to first understand the purpose and uses of options. There is always time to learn about the strategies (starting in Part Two).

    Suggestion: Before you trade options, it's essential that you have a working knowledge of the stock market. Because stocks and options are linked (some would say they feed off of each other), you should know how to invest in stocks before you can trade options. If you are new to the stock market, I recommend my previous book, Understanding Stocks (McGraw-Hill, 2003), which quickly and easily covers what you need to know about the stock market. There are many other books on this subject at your local bookstore.

    The Advantages of Trading Options

    Before we discuss options in detail, let's take a closer look at the reasons you'd want to participate in them. Did you know that options were created thousands of years ago? And they were popular well before the first stock market was created. You also might be surprised to learn that options can be included in anyone's portfolio, from conservative, risk-averse investors to speculators. Many traders love trading options because of their flexibility and low cost. No matter what your reason, you can find a way to use options—for income, for insurance, or for speculation.


    I'll discuss income strategies thoroughly in Part Two, but for now remember that options can be used quite effectively to generate income or cash flow. Basically, instead of buying options, you sell options on stocks that you already own. In a way, you are renting your stocks to other people, and they pay you for the privilege. This can be a profitable way to use options, similar to an annuity where you can receive cash each month just for holding the stocks.


    Another effective use of options is to hedge or insure your investments. Let's say you have a rather large position in one stock. If you prefer to reduce risk, you can use options to insure or hedge your stock position in case of disaster. Originally, options were created for just this purpose.


    Some speculators have caused options to have a reputation as a "get-rich-quick" casino. For very little up-front money, you can leverage your investments to make many times more than you put in. With this strategy, you are controlling a lot of shares of stock for a little bit of money. There are also strategies that allow traders with little money to make a lot of money. The best part of these options strategies is that you usually know in advance how much you could lose.

    Myth versus Truth

    Perhaps you believe that the only people making money in options are those who use the more advanced strategies. This isn't true! For the retail options trader, sometimes the simpler the strategy, the more money you'll make. And the more complicated the strategy, the more risk you take. Just stick with strategies that you are comfortable with—the ones that don't keep you up at night. This pertains to the stock market as well as to options.

    More than likely, it's too early for you to know the best way to use options. Many options traders use a combination of strategies: they employ options for income or cash flow and also for hedging against potential disasters. Obviously, many people are attracted to options because they can make many times their initial investment.

    Buying an Option on a House

    This short story should give you a general understanding of how options work.

    Let's say you are thinking of buying a particular two-bedroom house that is listed for $100,000. You really like this house and think the price is fair. You are eager to lock in the price at $100,000 in case it does go higher. If you can lock in the price, you'll have time to look at other houses and also time to act quickly if you decide to buy.

    So you approach the owner of the house to see if she will sign an options agreement. When she agrees, you sit down to discuss the terms. After a short conversation, the owner of the house agrees to hold the house for you for three months. During this time, no one else will be allowed to buy it. It also means that no matter how high or how low other offers may be for the house, you will be allowed to buy it for $100,000. Even if a realtor puts the house on the market for $120,000 within the next three months, you, and only you, are allowed to buy it for $100,000. The owner still pays the bills but you control when, if, and for how much the house will be sold. What a great deal.

    But what if the house goes down in value to $90,000, for example? According to the rules of the options contract you signed, you can just walk away if you want. In lawyer talk, you have the "right" to buy the house for $100,000, but you are not "obligated" to buy it. That means no matter how much the house is worth, higher or lower, you can buy the house for $100,000 or choose to walk away from the deal. (By the way, you will hear the word right, a lot, because options give you the right to buy or sell.)

    Perhaps you're thinking, "What does the owner get out of this transaction?" That's a good question. Because the owner is holding the house for you and can't let anyone else buy it, she will want some compensation; that is, she wants money. Typically, the owner will want a small percentage of the purchase price, perhaps 2 percent, or $2,000. So for $2,000, she will hold the house for you for three months. (By the way, the $2,000 you pay the owner is called the premium.)

    The owner is pleased because she gets $2,000 from you, which she can use as she pleases. You're happy because for three months you know you won't have to pay more than $100,000 for the house. In your opinion, $2,000 is a small price to pay for the right to hold this house. And if you change your mind during the next three months, although you will lose the money you paid the owner, you are free to look for another house.

    Let's see what could happen in real life. If the value of the house zooms up to $120,000, you decide to buy the house for $100,000 as previously agreed. Guess what? You just made a $20,000 paper profit.

    If you changed your mind or the price of the house dropped below $100,000, you aren't obligated or forced to buy it. You walk away from the deal with a $2,000 loss, but it's better than buying a house that has dropped in value.

    But what about the owner? She doesn't care if you buy the house; she's happy to receive the $2,000. And when the three months are up, if you don't buy the house, she could write another options agreement with someone else. This way she can continue getting these tidy little premium checks from potential buyers.

    Buying Options on Snow Shovels in Chicago

    To give you another example of how people use options in the real world, I have another story. Let's say that you own a hardware store in Chicago. You know that you'll probably need snow shovels in December. After all, last year there was a huge December snowstorm. Within weeks, you ran out of snow shovels, costing you profits and annoying your customers. This year, in August, you arrange an options agreement with the snow shovel manufacturer, Shovels, Inc.

    The options agreement specifies that Shovels, Inc., will provide you with 100 snow shovels for $15 each, although it normally charges much more. The options agreement specifies that you have the right to buy the snow shovels for $15 each until the third Friday in December. You don't have to buy the shovels, but you can if you want to.

    If it doesn't snow by the third Friday in December, you probably won't buy the snow shovels. Remember the premium in the first story? The manufacturer will charge you a $300 premium for holding the 100 snow shovels at $15 each. No matter what happens, whether you take delivery of the snow shovels or not, you will lose the $300.

    Why would Shovels, Inc., sell you an option on snow shovels? First, the company receives the $300 premium from you. Second, the company knows there is a chance you could buy the snow shovels, so an option to buy is better than nothing.

    Let's see what happens in the real world. If there is a brutal snowstorm in November and everyone needs snow shovels, the price of shovels will go up. You are delighted because you have the right to buy the snow shovels for $15 each. You accept delivery of the snow shovels and sell them to your customers for an even higher price. That will be very profitable for you.

    Let's say the Chicago winter turns out to be very mild. In this case, you don't want the snow shovels at all. You don't accept delivery of the shovels and the options contract expires. In this worst-case scenario you lost the $300, but at least you aren't stuck with the delivery of 100 unneeded snow shovels. In a way, the options contract was an insurance policy.

    If it's a mild winter, Shovels, Inc., keeps your $300 and the 100 snow shovels. In fact, the company will wait until January and sell an option on the 100 snow shovels to someone else. The money the manufacturer receives for each options contract will help it get through the mild winter.

    You might not realize it, but options contracts are written on thousands of products, from corn, soybeans, and oil to houses, snow shovels, and stocks.

    A Very Important Question

    Think about the following question: Would you rather be the options buyer or the options seller? The buyer is in control of when the property or product is bought or sold. But the seller receives the premium and must follow the terms of the contract. As we examine stock options further, you will learn strategies for both buyers and sellers. Meanwhile, think about which you'd rather be: the options buyer or the options seller.

    * * *

    The Early Years

    The Bible has the first recorded option transaction (the book of Genesis), involving a marriage agreement between Jacob and one of Laban's daughters, Rachel. The date of this transaction is estimated to be about 1700 B.C. Under the terms of this option agreement, Jacob had the "right" to marry Rachel but only if he agreed to seven years of labor. Apparently, Laban changed the terms of the agreement and insisted that Jacob marry his older daughter instead. Jacob was so determined to marry Rachel that he took out another option agreement for another seven years of labor. Finally, after fulfilling the terms of the contract, Jacob was allowed to marry Rachel.

    Many years later, Aristotle (384-322 BC) wrote a story about Thales of Miletus, a poor Greek astronomer, mathematician, and philosopher, which is the first written record of option speculation.

    According to Aristotle, Thales studied the stars to make unusually accurate predictions about future weather conditions, coming to the conclusion that the olive crop would be "bountiful," in other words, have an excellent season in the fall. Thales was clever enough to take advantage of his prediction. Although he didn't have a lot of money, he quietly approached the owners of the olive presses (the presses were used to convert olives into olive oil) to make an offer.

    He paid each owner a deposit (or premium) to reserve the olive presses during the harvest. For a small deposit, the owners would hold or reserve the olive presses for Thales during the autumn. Because no one believed that Thales could predict the weather nine months in the future, no one bid against him. Therefore, Thales paid very little for the right to reserve the olive presses.

    As it turned out, Thales's prediction was correct. It was an excellent year for olives and the demand for the olive presses was enormous. Thales sold his options contract (which was the right to use the olive presses) to the owners for a huge profit.

    The moral of the story: Thales proved to the world (and himself) that philosophers or speculators can become rich if they are clever enough to figure out how to use options in the real world. (It also helps to do your research before you invest.)

    Eighteenth Century

    The first options market in the United States began in 1791, when the New York Stock Exchange (NYSE) opened. Because options were still not considered part of the regular market, transactions were arranged in the less prestigious "over- the-counter" market. Options buyers and sellers had to walk around the floor looking for a match. Obviously, it wasn't easy to match buyers and sellers, especially before computers and telephones. There was no central place that buyers and sellers could meet to trade options. One of the ways buyers and sellers would meet was through newspaper ads placed by firms who had options they wanted to buy or sell.

    Nineteenth Century

    By the turn of the century, stock options were traded through a loose organization of over-the-counter dealers known as the Put and Call Brokers and Dealers Association. One of the problems was that no one knew what was considered a fair price for an option. Therefore, it was quite easy to make a bad deal and lose money. In addition, because no one guaranteed the options contract, traders were basically on their own. Finally, negotiating an option contract was difficult because the terms for each contract were unique. Unfortunately, traders had to wait another 100 years before the first organized options exchange was created.

    * * *

    Now that you have a general idea of how to use options, in the next chapter you'll learn how to open up an options account.

    Chapter Two

    How to Open an Options Account

    The two most common questions that people ask when interested in options are "How do you open an account?" and "How much money do I need to get started?" Both questions will be answered in this short but important chapter.

    By now, you may be anxious to place your first options trade. The best traders, however, wait patiently for the best investment or trading opportunities. If you step into options without knowledge or experience, you could lose money. Take the time to study options thoroughly before you place your first order. With that in mind, let's get started on learning what you need to do to open an account.

    The Five Steps to Opening an Options Account

    Because your brokerage firm handles all your options trades, you must begin with a brokerage account. After you have opened your brokerage account, you are then ready to open an options account. You can fill out the forms on the Internet or have them mailed to you. Once again, you must have at least a basic knowledge of the stock market to successfully trade options.

    After you've opened your brokerage account with the required minimum (the exact dollar amount varies with each brokerage firm but typically you'll need a minimum of $2,500), the brokerage firm will determine how much money you need to open an options account. Again, the exact amount varies from firm to firm.

    Step One: The Brokerage Firm

    In the old days, you had to rely on a stockbroker to make an options trade for you, but you paid dearly for the privilege. Because of the Internet, it's almost required that you make your own trades. This is one of the reasons why options commissions have dropped so dramatically, to as little as $10 a trade (or lower) in recent years.

    Nevertheless, when you first get started with options, there is nothing wrong with having the brokerage firm representative place the trade for you or at least confirm the trades that you make. (It will cost a little more if the representative makes the trade.)

    Although you should consider the expense of commissions when choosing an online brokerage firm, you also want knowledgeable representatives (they are no longer called stockbrokers), who will help guide you through the trades and discuss basic and advanced strategies. You also want a brokerage firm that has sophisticated options software and tools that can route your trades quickly to the best bid and ask price. In addition, you want access to educational materials like online tutorials and articles. It is also helpful if the reps are available to answer questions for you at least 12 hours a day.


    Excerpted from UNDERSTANDING OPTIONS by Michael Sincere Copyright © 2007 by The McGraw-Hill Companies, Inc.. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
    Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

    What People are saying about this

    Toni Turner
    "To me, the best books in the financial industry include topics that are well organized, have a reader-friendly style, and are filled with timely, compelling content. Understanding Options definitely meets these criteria. Michael Sincere's Understanding Options deserves a place in every investor's library."--(Toni Turner, best-selling author of A Beginner's Guide to Day Trading Online, A Beginner's Guide to Short-Term Trading, and Short-Term Trading in the New Stock Market)
    Mark D. Cook
    "Mike Sincere has been able to take a very complex subject, option trading, and detail it into an understandable book that may become the model for textbooks for teaching the basics. The flow of the book makes all readers eager to learn more and to approach options with an understanding of the investment vehicle."--(Mark D. Cook, developer of the COOK Cumulative Tick and winner of the Options Division of the U.S. Investing Championship)

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    Understanding Options 4.3 out of 5 based on 0 ratings. 4 reviews.
    Marc22 More than 1 year ago
    There are many stock option books out there that are really complex. This book presents the terms in a way that a beginner can understand. I have successfully utilized some of the strategies listed in this book. I frequently trade covered calls and found the various techniques shown to be very helpful. I would recommend this book to option traders from beginner to experienced. Marc http://www.rebuildingmyfuture.com
    Guest More than 1 year ago
    The world of trading opportunities which opens up once you learn about options is quite overwhelming. But the good news is that you only need a few simple ideas to greatly improve your trading results. This book has made me small fortune while minimizing risk.
    Anonymous More than 1 year ago
    This book was great, if you are looking to get started in trading options this is the book. It breaks it down in a way that everyone can understand. I learned to trade covered calls and this book has already paid for itself.
    Anonymous More than 1 year ago