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In This Chapter

Increasing your stock profits with options

Recognizing the characteristics of calls and puts

Locating online option quotes, news, calculators, and screens

Avoiding mistakes by testing your strategies online

Selecting the best option analysis software
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In this chapter, I explain how purchasing stock options can assist online investors to make money in a bear or bull market. Here, you find the basics of online investing in stock options, as well as discover which Internet sites provide guidance, news, quotes, online tools, and software to help you leverage your investment dollar. You can uncover which exchanges list stock options and also gain an understanding of the online brokerages that specialize in these types of transactions as well as the commissions that they charged.

Suppose that a well-known novelist decides to let Hollywood make a movie based on one of her books. The novelist receives a payment from a Hollywood producer for the option of deciding within a specified time to make the movie. If the Hollywood producer decides to go ahead and make the movie, the novelist sells him the screen rights. If the Hollywood producer changes his mind, the novelist keeps the option payment and her novel.

Trading stock options is a similar transaction. Options are contracts between a buyer and a seller. These contracts represent the right of the investor to buy or sell shares of the stock that the shares represent, called the underlying stock. Contracts are usually for 100 shares and don’t oblige the investor to purchase or sell shares of the underlying stock.

Types of option contracts
An option is a contract between a buyer and a seller. An option contract that gives the owner (holder) the right, if exercised, to buy or sell a security or index at a specific price, called the strike price, within a specific time period. Option contracts are generally available for one to nine months, although some longer-term options are available on selected securities. Each contract usually equals 100 shares of stock. Calls and puts are two types of options, and I explain them in the following sections.

Why buy stock options? Stock options enable investors to position themselves for a big market move even when they don’t know which way stock prices will move. For example, the cost of the premium (the amount paid for the option contract) is often less than what the investors would lose if they purchased shares that later suffered a steep price decrease.

Stock options enable large and small investors to leverage (the wherewithal to control large amounts of a financial asset with a somewhat small amount of capital.) their investment dollars. For example, a stock might increase by only 25 percent, but the investor receives a 100-percent return on his or her cash investment in the stock option contract. However, if the stock experiences a decrease or remains at the same price, the investor suffers a 100-percent loss of the premium paid for the stock option contract.

Short rallies exist even in a down market. With options, investors can exercise an option during one of these peaks to gain short-term profits. If the rally doesn’t materialize, the only loss the investor suffers is the cost of the premium paid for the options contract.

Some large corporations, such as insurance companies, want to reduce their exposure to the market. They sell their options to offset losses incurred by their current stock holdings. Individual investors can limit the exposure of their personal portfolios (especially in a volatile market) in the same way.

Exercising your stock option
All stock options have exercising dates that are stated upon the option’s introduction to the market. During this time, the same stock option can be bought and sold many times. To exercise the stock option, you can do one of three things:

• Buy or sell the underlying shares of stock (exercise the option). Shares purchased can be held for long-term gains. Shares sold realize an immediate capital gain.
• Sell the option on the open market. Profits from the sale of your option are automatically credited to your trading account and are taxable.
• Let the option expire. If the option expires, it loses all value.

Call options
A call is defined as the right to buy a specific number of shares at a specified price by a fixed date. If the stock is above the agreed-upon price by the fixed date, the investor wins — he bought the stock for less than what it’s worth that day on the market. For example, you believe that IBM is underpriced. You purchase a 3-month call at $100 when the stock is selling at $90. The call options selling price is $3 per share, which is the premium. You purchase ten contracts (of 100 shares). You now control 1,000 shares. The total amount of the premium is $3,000 — that is

$3 (the option selling price) * 10 (contracts) * 100 (shares) = $3,000

One month later, IBM’s shares are selling for $110. You can now either

• Exercise your option by purchasing 1,000 shares at $100 and then sell the shares at $110 for a profit of $10,000 less commission (the premium). Before taxes, you would net $7,000.
• Sell your call option, which is worth approximately $10,000.

Using call options has two advantages. First, you need less cash to control a large number of shares. As you can see in the preceding example, the purchase of the option was $3,000, and the cost of purchase of the shares is $90,000. Second, if the IBM stock price severely drops, an investor who owns the shares loses more than an investor who owns only the option.

Put options
A put option contract gives the holder the right, but not the obligation, to sell 100 shares of common stock at the strike price on or before the date of expiration. For example, thinking that IBM is way overpriced, you buy 10 IBM February puts at $2 per contract. That is, you buy 10 contracts, and each contract represents 100 shares of stock, so you control 1,000 shares. Here is the game plan:

• IBM is the stock.
• February is the month when your option expires. Options always expire the third Friday of the month.
• $100 is the strike price.
• $2 is the price you paid per contract.
  Well, actually, $2 is the price per share that you control — so buying 10 of these puts (1,000 shares total) costs you $2,000 plus commission.

As the owner of this put, you have the right (but not the obligation) to sell up to 1,000 shares of IBM at a price of $100 per share anytime between the February day when you buy and the third Friday of February. Most people wouldn’t do this because it’s complicated. Selling the contracts that you’ve bought is easier (just as you would sell stock) and often just as profitable.
Suppose that you pegged IBM correctly, and its price drops sharply. Say the value of your put increases from $2 to $10. You sell at $10 and make a huge profit.

In the event that you’re wrong and IBM keeps going up, your option expires worthless. All you lose, however, is the $2,000 that you initially invested (and any brokerage fees). The appeal of options is that you have unlimited upside potential. You can make five or ten times your initial investment, but you can never lose more than what you initially invested.

Many helpful Web sites can assist you in getting a grip on buying and selling options. Some of the better sites are sponsored by option brokerages and exchanges. Here are a few examples of what you can find online:

• Chicago Board Options Exchange offers many educational resources. The Trading Tools section includes delayed quotes, charts, news, market data, company research from Zacks , and an options calendar.
• Optionetics offers help on topics such as understanding basic and advanced option concepts, option strategies, understanding investment proofs, and suggestions for selecting a broker.
• Options Industry Council is an industry trade group that supplies access to educational material and free educational seminars across the country. It offers 12 online training courses. The Options Industry Council (OIC) invites you to expand your options knowledge by attending one of its three free educational equity option seminars (LEAPS Seminar, Practical Applications Workshop, and Basic/Intermediate Seminar). Exchange professionals teach the OIC seminars, which take place from 6 to 9 p.m. Check the Web site to find out when a seminar will be held in your area.

Online sources for option quotes
To make intelligent investment decisions about your stock options, you need the latest stock quotes. (It’s the only way to tell whether you’re making money or you’re out of the game.) The following Internet sites provide realtime and delayed option quotes:

• INO.com features information on stocks, options, futures, and currency, as well as intraday (delayed) daily and weekly charts.
• Chicago Board Options Exchange offers delayed quotes. Just enter the stock or index symbol; for most searches, click List Near Term At-The-Money Options. For volume leaders (the most active options), go to this page .
• Philadelphia Stock Exchange offers quick links to New Options Listings and 15-minute-delayed options quotes. Click Marketplace and then Quotes for easy-to-read information.
• U.S. Futures & Options offers quotes and charts, news, commentaries, book and software suggestions, and much more.

Online sources for options news and data
Option prices are affected by many variables including time, market expectations, market volatility, stock price, dividend yields, and other factors. The Internet provides many sources of information about these variables, including the following:

• Covered Calls offers tools, data, and resources to options traders. Discover how to write a covered call and follow an ongoing case study. Don’t forget to check the list of covered calls that pay 10 percent or more.
• OptionSmart shown in Figure 16-1, provides stock quotes, news, broker reports, charges, analysts’ reports, and research based on technical and fundamental analysis. The Web site has free and fee-based content. Several types and levels of subscription services are available with a free ten-day trial.

Figure 16-1

• Options Industry Council offers FAQs of the Week, strategy information, and 20-minute-delayed options quotes. Check out the useful glossary, as well as a basic and advanced option-pricing calculator.
• PitNews.com provides daily derivative market news and commentary. You find a futures forum, commodity prices, an education center, and information about futures seminars.
• SchaeffersResearch.com offers a well organized but somewhat busy Web site loaded with tools, data, and educational features. Type a ticker symbol for detailed quotes. Features include best trades, year-to-date returns, and more. SchaeffersResearch.com offers a variety of fee-based products and services. Two examples are The Option Investor newsletter for $149 per year and online access to Schaeffer’s Gold section that includes commentary, tools, data, and filters for $9.95 per month. The Gold section has a free 30-day trial.

Just like mutual funds and stocks, options have online screeners and calculators to assist you in valuing and screening investment candidates.

• optionsXpress offers the Trade & Margin Calculator, which graphically illustrates the buying power required and potential profit or loss of a trade. In other words, you can easily calculate the investment risk or reward of your potential trading order without losing a dime. To sum it up, the Trade & Margin Calculator lets you test your knowledge and grow your experience on paper.
• PowerOptions offer four levels of content and services. Limited access is free with your registration. PowerOptions Essentials, at $9.95 per month, includes limited access to the Web site, 20-minute-delayed quote position reports, full access to the help section, and lots of research. PowerOptions Plus is $59.95 per month for unlimited access to the Web site, 20-minute-delayed searches, and option chains to find high return option positions. Subscribers have access to more than 150 pages of tools and articles. PowerOptions RT is $79.90 per month and includes everything you get in the PowerOptions Plus subscription but with real-time prices, investment opportunity search, calculations, and option chains.
• Chicago Board Options Exchange offers both free and fee-based trading tools. The CBOE and IVolatility have partnered to bring you a suite of option analysis and strategy tools. Free services include IV Index, which offers basic end-of-day information. The Option Calculator brings you features that were previously available only to professionals. You can customize all the input parameters (option style, price of the underlying instrument, strike, expiration, implied volatility, interest rate, and dividends data) or use the IVolatility database to populate all those fields for you. Both services are free. Fee-based services include Strategies Scanners & Worksheets, Advanced Volatility Ranker, Advanced Options, and Spread Scanner. Each premium service offers a free trial.
• Options Industry Council offers a basic calculator and an advanced calculator. The basic calculator walks novices through the process of setting the variables that affect the price of an option. This calculator provides an explanation of all input variables and the output generated (theoretical prices and risk parameters). The advanced calculator provides those users who are familiar with option trading with a fast interface. The advanced online calculator has an additional feature that allows users to calculator theoretical option prices and risk parameters over a range of strike prices.
• SchaeffersResearch.com provides a Portfolio Protection Analyzer. This hedging calculator estimates the value of your portfolio if it declines 5, 10, 15, or 20 percent. Then it suggests the amount of puts that you should purchase to protect your portfolio.

The value of the stock option is derived from an actual stock or equity. The price movement of the underlying stock makes the value of the option increase or decrease. This price movement is the intrinsic value, or fair value, of the stock. (See Chapter 8 for more information on determining the fair value of stocks.)

In addition to their intrinsic values, options also have time values, which reflect what the holder is willing to pay for an option in anticipation of a stock price increase before the expiration date. Most options are for nine months, and the option can be bought or sold many times during this time period. As an option gets closer to the expiration date, the value of the option can decrease, increase, or remain unchanged, depending upon the current value of the underlying stock. Just before the expiration date, the time value becomes zero.

The Chicago Board Options Exchange (CBOE) provides many materials for novices to check out, including an excellent introduction to options, profitable trading strategies, answers to frequently asked questions, a glossary of option terms, and a schedule of educational events and seminars for beginning investors. To access these materials, go to the CBOE home page and click Learning Center.

Investors often use stock options to hedge their bets or to gamble on the future. Investors need to know four things to make a good investment decision:

• Name of the underlying stock: The name of the underlying stock or equity. The name could be a company that your analysis shows might soon rapidly increase — a company stock that you want to purchase but can’t afford. You might want to select stock options for a company in which you already own stock to protect your portfolio from a marketdriven decline in price.
• Strike or exercise price: The stated price per share for which the underlying security can be purchased (in the case of a call) or sold (in the case of a put) when you exercise the option contract. Option contracts are usually for 100 shares. The higher the exercise price, the lower the value of the call option. (See the section “Types of option contracts” for
  more on calls and puts.)
• Expiration date: Option contracts are for three, six, or nine months (or remaining fractions thereof) on three calendar cycles. Cycle 1 is January/April/July/October; Cycle 2 is February/May/August/November; and Cycle 3 is March/June/September/December. As the option approaches the expiration date, the value of the option decreases. Options usually expire at midnight EST on the third Friday of the expiration month.
• The premium paid for the option, plus the broker’s commission: The price of the option contract is the premium. All things being equal, the longer the time period of the option, the higher the premium. The commission is the amount that you, as the investor, pay the brokerage for executing the transaction of purchasing the option contract.

optionsXpress offers virtual trading, which is a practical method of gaining experience with options trading without risking any of your precious capital. All your trades are tracked on paper only. Virtual trading is useful because you make decisions and experience the results of those decisions in real time. Virtual trading is available to individuals who open an optionsXpress trading account. No minimum amount is required to open a cash account; there is a $2,000 minimum to maintain a margin account.

Taking a closer look at options
Using the business school approved intrinsic value method, a stock option’s value is equal to the difference between the option strike price and the fair market value of the stock. For example, suppose that you’re granted an option to purchase 100 shares of the company’s stock for $10 each. The stock sells for $54. The intrinsic value of the option is $44 because $54 – $10 = $44. The intrinsic value is a positive number, so the option is in-the-money. However, this formula doesn’t consider brokerage fees or interest fees on a margin loan from your broker, which can reduce the actual gain you realize.

Keep in mind that the intrinsic value method also doesn’t consider that option holders have the right to use their options at some time in the future, which can result in a greater profit or loss if the trading price of the underlying stock falls.

myStockOptions.com with your free registration, provides step-by-step instructions that help you to determine exactly how much money you’ll take home (after taxes) if you exercise your stock option today. Use the Quick Take Calculator by entering the number of shares in your stock option grant, the exercise price, and the company’s current stock price and then click Calculate. What makes this calculator unique is that it applies taxes to your transaction. You can even use the myStockOptions modeling tool to perform a what-if analysis. For example, enter a percentage increase or decrease under the What If Company Stock Price to determine an ideal selling price.

Discovering what your options are worth
The first step in understanding what your options are worth is to be able to understand an option premium table. Premiums (prices) for options that are traded on stock exchanges are published daily in newspapers and online. Table 16-1 shows what a typical listing looks like.

Use this guide to help you understand some of the key elements in Table 16-1:

1. Identification of stock: This is the ticker symbol for the underlying stock.
2. Stock closing price: This is the closing value of the stock on the New York Stock Exchange.
3. Option strike price: The strike price is the stated price per share that the underlying stock can be purchased for (called) or sold (for a put) if the option contract is exercised. Option strike prices usually move by increments of $2.50 or $5. In this example, the strike price moves in $5 increments.
4. Option closing prices: This is the closing value of the option contract.
5. Option expiration months: This shows the termination date of an option contract. Remember that U.S. listed option contracts expire on the third Friday of the expiration month.

In Table 16-1, XYZ July $115 calls closed at 31⁄2 ($350) per contract. XYZ stock closed at $112bf3/8. Therefore these options were out-of-the-money because the closing price didn’t reach the $115 or greater.

Puts are the opposite of calls. Table 16-1 shows how a put must be greater than $1123⁄8 to be in-the-money. The July $120 puts closed at 83⁄4 ($875) per contract. Therefore, in this example, these puts are in-the-money because $120 is greater than the closing price of $1123

Online brokerages and options
Not all electronic brokerages trade stock options. The sales commissions for option transactions vary from broker to broker. Some online brokerages charge a flat rate plus $1.50 to $2.50 per contract. Others just charge a flat fee. See Table 16-2 for a few examples of online brokerage commissions for options transactions.

Online brokerages that specialize in options trading frequently offer investors unique tools for research and analyses. For example, optionsXpress is an online brokerage that doesn’t require a minimum initial deposit for opening a trading account. The commission fees are $1.50 per contract. The minimum number of contracts you can trade at one time is ten — or if you trade less than ten contracts, you’ll pay $14.95.

The CBOE offers a listing of options brokerages. The brokerages aren’t endorsed by the CBOE and will require your investigation. Many of the listed option brokerages don’t have Web sites, so you’ll have to contact some brokerages by phone.

Optionetics provides useful reviews of top options brokers. You can compare brokers by site design, user friendliness, options usefulness, option trading cost, and so on. You can also find useful information about what you need to know about your broker, such as questions you should ask your broker.

Option analysis software tools measure the probability of profit and identify profit goals and stop-loss points while often providing prebuilt strategies or allowing simulations of investor strategies. As an investor, you’ll find all this information valuable. Each year, software developers spend hundreds of thousands of dollars developing these software tools and often sell the product for a few dollars.

Investors can frequently get their favorite tools enhanced and upgraded on a regular basis. With all these great programs available, selecting the one that meets an individual investor’s specific needs can be difficult. Table 16-3 lists some of the analysis software that can help you maximize your returns with stock options.

Options software can assist you with

• Creating computer-generated strategies
• Taking risk measurements
• Experimenting with multiple pricing models
• Graphing your option analyses
• Forecasting or making projections using what-if analysis

If you can’t determine whether investing in options is for you, and you don’t want to spend a lot of money on a software program, I suggest trying one of the demos that I list in Table 16-3. Or you can download one of the more limited software programs at Shareware.com . Just select your operating system — Windows, Mac, Linux, and so on — and enter Stock Options in the search box. Click the Search button. The options software at Shareware.com comes from several third-party sources. The shareware includes freeware (no cost), shareware (try it for free), and company-sponsored no-cost demos.

More experienced options investors are likely to be interested in the latest strategies for different types of markets. Often discovering a new strategy can help you increase the amount of your profits (or decrease the amount of your losses).

• Chicago Board of Trade offers many regularly scheduled Webinars, tutorials, and trading strategies that can assist you in becoming an educated options investor. Note: Don’t forget to check out the strategies archive.
• optionsXpress offers Strategy Scan, which is a valuable tool that allows you to develop an investment approach based on your option of the market. Through a series of drop-down menus, you enter your bullish or bearish opinion of a stock, your investment time frame, your experience, and investment (risk) amount. After you enter Strategy Scan, it shows you up to three opportunities with potential profit and loss amounts for each action, and a ready-made link to preview each trade. To get started, you need a trading account, but opening an account online takes only about ten minutes, and no minimum initial amounts are required to open an account.
• Options Industry Council provides nine preset trading strategies that are explained so that beginners and more sophisticated options traders can easily understand the results of their decision-making. At the home page, enter the Learning Center and choose Strategies. Then click Strategy Index.
• SchaeffersResearch.com offers a topnotch primer on basic option strategies, such as straddles, spreads, and hedges. This Web site is designed for beginning and experienced investors who are serious about investing in options. Click the Education tab for an online tutorial.