Blog > Investment Research > Use options to leverage powerful gains
Share this article:
  • Print
  • Digg
  • del.icio.us
  • Facebook
  • Google Bookmarks
  • NewsVine
  • StumbleUpon
  • Twitter

Use options to leverage powerful gains

Today's Financial News - Posted March 23, 2009

By Andrew Snyder, TodaysFinancialNews.com

Options get a bad rap. Back in grad school, I remember a fellow student telling a professor in a derivatives class, “Options are something for coked-out Wall Street guys.”

It got a good laugh but he could not have been more wrong.

As a long-time student of the options markets, I knew my classmate was in for a treat. By the end of the semester, that same student was as well-versed in options as anybody on Wall Street and even more importantly, he was using them as an integral tool to manage his portfolio.

Now that he knows the whole story he calls options, “portfolio insurance he would not live without.”

That’s more like it.

I dare you to find any portfolio manager, no matter how conservative their style, and ask them their thoughts on options. I am positive every single one of them will say something to the tune of, “I would not be in the business without them.”

It is true. Options are any serious investors strongest tool. They offer leverage, speculation and an incredible opportunity to hedge almost any investment.

If the pros rely on options, why don’t you?

There are multiple ways to use the power of options. You can use them to create insurance against wild market swings or you can use the incredible leverage produced by the options market to rake in triple-digit speculative gains.

Creating portfolio insurance is personal business. It takes a strong understanding of your unique risk and reward factors. I will leave the hedging to you and your broker.

I want to show you how to use the leverage produced by options to maximize your profit potential. To do it, first you must understand options and how they work.

If you are new to options, this report will give you a down-and-dirty overview of the most basic of options strategies. It would be misleading if I said it tells you all you need to know about risk analysis and management.

For that information, look to your broker. They are required to provide you with all the information you could ever ask for.

Let’s make some money

To start, an option is a type of derivative security. In other words, it derives its value from another asset, which is called the underlying asset.

Options give their owners the right, but not the obligation, to buy or sell an asset at an agreed-upon price some time in the future. There are options on stocks, stock indices, commodities, currencies, futures, you name it.

First off, there are two types of options: calls and puts:

  • Call options give their owners a shot at gains if the underlying asset increases in value. Buying a call typically means an investor is bullish on a security.
  • Put options represent a bullish sentiment. They allow an investor to profit as an underlying asset declines in value. They give their owners the right, but not the obligation, to sell an asset at a predetermined price.

One of the most complex notions surrounding options is that they are not indefinite assets like a stock. All options come with an “expiration” date, the date at which they must either be exercised or they will be worthless.

After this date, the option owner no longer has the right to buy or sell the underlying asset.

This is an important fact because the expiration date affects the option’s value. When valuing an option, you must realize there are two components to an option, its intrinsic value and its time value.

Setting an example

Let’s dig deeper by looking at a typical call option…

As I write, Ford (NYSE:F) has a set of options that will expire in June. We can choose from one-month, two-month, four-month, six-month and ten-month options, but randomly we will choose June.

Right now, shares of Ford are selling for about $2.50. So if we are looking at call options, we probably expect that share to rise. That means we can look at a wide range of strike prices, ranging from $3 the whole way up to $40.

If you are not familiar with the term strike price, it simply means the price at which you have the right to buy the underlying asset.

When the underlying asset is trading below the strike price, the option is considered an out-of-the-money option, because you would not want to exercise it and buy the stock for more than its current market price.

When the stock is trading above the option’s exercise price, the option is called an in-the-money option, because it would make financial sense to exercise the option and take advantage of your option to purchase shares at the exercise price.

Back to the example…

We have many exercise prices to choose from, but let’s choose the closest contract to the current stock price, the June 3.00 calls. They are currently trading for $0.21.

Now, it is important to realize, each contract represents 100 shares of the underlying asset, so the true price of these calls will be $21. But typically when options traders discuss contracts, they take a per-share vantage point. It helps to keep things simple.

Let’s look at a few possibilities that could happen if we purchase these Ford options. First, if we are willing to pay $0.21 for the option to buy underlying shares at $3.00, that must mean must believe share price is going to go above $3.21, which represents the combined price of stock and the option.

Let’s say we are right and Ford’s share price soars all the way to $5. How much would those options be worth?

This is where we get into time value versus intrinsic value.

When we bought the options, they were out of the money because share price was below the options strike price. That means the $0.21 price we paid represented time value. It was what we were willing to pay based on what we thought the probability of the stock price rising above the strike price.

If we believe there was just a slight chance of shares trading for more than the strike price, we likely would have paid much less. And if we thought it was a near certainty that shares would trade above the $3 strike price before the options expired, we would have been willing to pay even more. The higher we thought shares would rise, the more we would pay.

Now we have reached the option’s expiration date and shares are trading for $5. With no time until expiration, there is no time value. That means there is only intrinsic value.

In this case, when the underlying shares are trading for $5, that value is $2, the difference between the price of the underlying asset and the strike price ($5 minus $3).

So if shares of Ford are $8 at expiration, how much would the options be worth?

Hopefully, you said $5.

How about if shares are trading for just $3.50? Then the options would be worth just $0.50.

What about if shares are trading for exactly $3.00 or below? How much would the option to buy shares at $3.00 be worth? Nothing. There is no intrinsic value or time value. Why would you be willing to pay for an option when you can simply buy the underlying asset at the same price?

Set to expire

At their expiration date, when they are trading with no time value, options are easy to price. But add in time value and things get dicey. This is where the notion of implied volatility comes into play.

Options jump up and down in value based on the market’s belief of where share price is headed. The more the market thinks shares are going to rise, the more volatility the option’s price will represent.

Back to our Ford calls…

Let’s say there is one month until expiration and shares of Ford are trading for $3.50. Remember, if they expired right now, these options would be worth $0.50. But with a month to go before they expire, any number of things could happen.

If share price goes up, the option’s value will go up. If share price goes down, the option’s value will go down. But how far?

There is a nobel-prize winning formula that helps the pros lock in figures, but even that equation creates plenty of room for misguided estimations.

Instead of dissecting a page-long formula, let’s continue our example..

If you believe Ford’s share price will continue to rise to $3.90 within the next month, you will be willing to pay at least an extra $0.40 for the options. That means there will be $0.50 of intrinsic value and $0.40 of time value.

The higher the market believes share price will go, the more time value will be added to the option’s price. The key is understanding the likelihood or the probability of the underlying shares to reach that price. If the probability is high, the option’s price will be higher. If the probability sinks, well, you know what will happen.

It may sound complicated, but it really isn’t.

Time value merely represents what the market believes is going to happen to share price over the days until expiration. The more volatility and the greater the chance of a rise in share price, the more time value will be added to the option’s price.

For options traders, this can lead to huge profits.

Now, what if shares of Ford do not make it to $3.00 and are trading for just $2.20. How much would the options be worth?

Time is money

It all depends on how much time is left until the options expire.

Remember, if they expire out of the money, they will be worthless. So if there is just one day left until that critical date, they may be worth just a penny or two, depending on the market’s belief they will climb above the strike price. Again, the higher the probability of expiring in-the-money, the higher the option’s selling price.

If there is 25 days until expiration and investors believe there is still a good chance of climbing over the $3.00 strike price, the options may be selling for $0.20 or even $0.50, it all depends on what the market currently believes.

As you may be starting to realize, options investors profit when the market’s beliefs turn out to be wrong or new information changes its estimates.

Options prices will change when the probability figures move up or down. By understanding the direction and velocity of stock price changes, investors using the leverage created by options can reap huge returns.

Playing the downside

Even after mastering calls, many investors are too timid to tackle puts. They have no reason to be. They are merely the inverse of calls. When a stocks price drops below the put’s exercise price, the options increase in value.

An in-the-money put is one with the stock trading below its exercise price and an out-of-the-money put is one with the stock trading above its exercise price. Again, it is the opposite of a call.

It may sound complicated, but I promise you after a few trades (I recommend starting with paper trades), it is as easy as buying a stock… and the rewards are much, much higher.

Finally, an options trader is never done studying new strategies or old ones. There are dozens of techniques you can use to your advantage. If you are interested in learning more, I encourage you to check out my options-trading service, TFN Strategic Trader.

We use the leverage of options to play the market’s moves and have been racking up some fantastic profits, even in the face of one of the century’s worst bear markets. To learn more about the service and how to use options to your advantage, click here.


Next Article: Gold: The latest cure for cancer

Posted by Andrew Snyder · Filed Under Investment Research, Options 

Share this article:
  • Print
  • Digg
  • del.icio.us
  • Facebook
  • Google Bookmarks
  • NewsVine
  • StumbleUpon
  • Twitter

 Add to Technorati Favorites | Follow Us on Twitter!

Be the first to leave a reply.

Your comments are welcome