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In Winning with Options, Michael C. Thomsett offers nontechnical, easy-to-follow advice on important techniques related to portfolio management, such as diversification and risk management. You will discover how to: choose the right brokerage firm - use online resources - pick the right stocks - track options - set portfolio and risk goals - understand the complicated world of options lingo - make the most of day trading and swing trading. Straightforward and practical, this is the one book that will help you navigate the sometimes daunting but always rewarding world of trading and investing with options.
C H A P T E R 1
A FEW BASICS
One of the greatest pieces of economic wisdom is to know what you do
—John Kenneth Galbraith, in Time Magazine, March 3, 1961
Imagine investing in a company, holding shares of stock
for the long term while earning a nice dividend each year,
and watching your portfolio grow over time in a robust
and healthy economy. Now imagine expanding this idea to
create additional benefits. These include being able to take
profits when they occur as a result of short-term overreaction
in the market, to protect your stock against price declines,
and to use your shares of stock to increase current
income each and every year—when the stock rises and
when it falls.
That environment does exist. With the careful, wellplanned
use of options, you can manage your portfolio to
reduce overall risk while increasing current income. At the
same time, you can satisfy the urge to speculate without
placing your long-term investments at risk. You might not
think of yourself as a risk taker, but most people like to
imagine what it would be like to play short-term price
movement and make a little extra money doing so. If you
are typical, you probably have not gone down that road
because you do not want to place your investment capital
at risk, and that is a legitimate reason to play it safe. However,
this book lays out a series of strategies involving
options that you can use to create the ideal stock environment
without added risk. Options are flexible and present
many great opportunities, making them a practical income
generator and risk-reducing device.
■ Ground Rules for Stock Selection
You have probably heard about options in terms of high
risk and high loss. They are often seen as speculative ‘‘side
bets’’ that only the high rolling risk taker wants to use. But
this is not necessarily the case. A large number of option
strategies are actually low-risk and worth considering even
in the most conservative portfolio.
To establish a clear definition of options and how they
work, you need to be aware that an option is merely a
‘‘right.’’ It has no tangible value and only grants its owner
the ability to transact stock at a predetermined price. This
gets interesting when the stock price moves above or below
that set price. The more the movement of the price, the
more valuable the option becomes—because the option
fixes the price of the stock, no matter what its market price
is at the time.
To understand this in a way familiar to many people,
consider the case of a real estate lease-option contract.
Under this deal, a person who wants to buy a home enters
into a lease with the owner, agreeing to pay a specified
amount of rent for a period of years. In addition, the contract
specifies that at any time before expiration of the
lease, the tenant also has the right (the ‘‘option’’) to buy
the house at a specified, fixed amount. Therefore, even if
the market value of the home doubles, the tenant has the
contractual right to exercise the option and buy the house.
Numerous possible outcomes can occur, as shown in the
You want to buy a house currently valued at $265,000 but
you do not have the down payment. You believe that you
can save up enough to buy the house within three years,
so you offer the owner a lease-option. It specifies that you
will make lease payments over a 36-month period, and
also that at any time you can exercise an option to buy the
house for $265,000. At the end of the lease term, the option
expires. Several outcomes may occur:
• You are unable to save enough, or the house actually
declines in market value. You allow the lease to expire
without taking any action.
• The house doubles in value to more than $500,000 and
you exercise the option. The owner is required by contract
to sell the house to you for $265,000.
• The property increases in value and the owner does not
want to sell, so he offers to buy your option from you.
The price is negotiated based on current market value
versus the option value of the property.
The kind of real estate transaction shown in this example
occurs quite often. Now apply the same concept to the
stock market and you have a fairly good idea of how it all
works. For the price you pay to buy an option, you fix the
price of stock. A call option gives you the right (but not the
obligation) to buy 100 shares of a specific stock, on or be-
fore a specified deadline (the expiration date), for an exact
price (the strike price). The opposite is a put, which is an
option granting its owner the right to sell 100 shares of
stock on or before expiration and at a specific strike price.
For option sellers, the rights are ceded to buyers. The rules
for both types of options are summarized in Figure 1-1.
Before jumping in and starting to buy (or to sell) calls
and puts—or before investing in stock with option trading
in mind—you need to consider the risk elements, not only
of options but also within your stock portfolio. As a starting
point, a series of commonsense rules will help you to
keep your stock portfolio and options in perspective. First
is the ‘‘rule’’ that your long-term portfolio objectives
should govern all of your decisions:
Rule 1: Pick stocks based on your well-defined objectives
and risk tolerance levels, and never based on potential
gains from options. Too many first-time option
investors make the mistake of picking stocks based on the
value of related options. Another mistake is keeping highrisk
stocks in your portfolio because options are poten-
tially profitable, when you would otherwise sell and replace
those shares with safer stocks.
Rule 2: Be sure the stocks you hold are appropriate
for you, and when that is no longer true, sell and replace
The third rule to remember is related to the long-term
nature of most portfolios.
Rule 3: Select stocks based on your belief about longterm
price appreciation, above all other considerations.
This final rule is the basic ‘‘value investing’’ approach.
Under this premise, any long-term hold stocks should be
in highly-valued, well-managed, competitively dominant
companies whose stock you can buy at a bargain price
(and then hold for the long term). Although this premise
makes sense, it does not preclude options. In fact, value
stocks are often the best stocks for various option-based
strategies, assuming that you first apply the fundamental
rules for stock selection.