Options

[BadThad]

Ripped from Marketwatch today:

How to buy ... options
12:01a ET September 13, 2007 (MarketWatch)
SAN FRANCISCO (MarketWatch) -- Puts, calls, strike price, in-the-money, out-of-the-money -- buying and selling stock options isn't just new territory for many investors, it's a whole new language.

Options are often seen as fast-moving, fast-money trades. Certainly options can be aggressive plays; they're volatile, levered and speculative. Options and other derivative securities have made fortunes and ruined them. Options are sharp tools, and you need to know how to use them without abusing them.

Because options have this rogue reputation, their pragmatic side is frequently overlooked. Thinking about options as an investor, not as a trader, gives you, well, more options. Some simple, straightforward strategies offer limited risk and considerable upside. At the same time, conservative investors can rely on stock options as a source of income and a protective hedge in market declines.

"Options are not vehicles just for the purpose of speculating," said Randy Frederick, director of derivatives at brokerage Charles Schwab & Co. "They actually have far better uses for purposes of income generation and risk reduction."

What to watch for:

Stock options give you the right, but not the obligation, to buy or sell shares at a set dollar amount -- the "strike price" -- before a specific expiration date.

When a "call" option hits its strike price, the stock can be called away. Conversely, with a "put" option the shares can be sold, or "put," to someone else. The value of puts and calls depends on the direction you think a stock or the market is heading. Stated simply, calls are bullish; puts are bearish.

The beauty of options is that you can participate in a stock's price movement without actually holding the shares, at a fraction of the cost of ownership, and the leverage involved offers the potential for sizeable gains.

Of course, this doesn't come free. An option's value, and your profit potential, will be impacted by how much the stock price moves, how long it takes and the stock's volatility. You can be right on direction but run out of time, since options expire, and trading activity might not work in your favor. In addition, leverage cuts both ways.

The Chicago Board Options Exchange makes a market on almost 2,000 U.S.-listed stocks. Its Web site, www.cboe.com, features a learning center with in-depth information about options investing. The Options Industry Council, www.888options.com, also provides extensive tutorials. And investment researcher Morningstar Inc., www.morningstar.com, recently began advising investors about options. See related story.

There are dozens of complicated options strategies, some more speculative than others, but two of the most conservative uses of options are to generate income and to cushion a portfolio from downside risk.

To produce income, you sell calls on shares you already own. This is known as writing a "covered call" or a "buy-write" strategy.

Here's how it works: Suppose you own 100 shares of Intel Corp. and you think the stock won't be much higher, if at all, over the next few weeks. Intel is trading at around $25.50 a share. You can sell an October call -- the right to own 100 shares -- at a strike price of $25 and pocket a "premium" -- in this case, of almost $140.

If Intel shares stay below $25 by the third Friday in October when the option expires, you keep the premium. The premium received also gives some downside protection -- $140 compensates for a $1.40 drop in the shares, equivalent to a 5.5% decline in the stock.

The trade-off is that writing a covered call gives up any substantial appreciation, in this case a move beyond the $25 strike price plus the $140 premium, or about $26.40 a share. If the stock is higher than $25, the option will be exercised and your shares will be called. But you would make a 3.7% return in just over a month. And since you own 100 shares, you are completely covered for their delivery, hence the term.

"The covered call has limited downside protection and also delivers limited upside potential," Joe Cusick, senior market analyst at OptionsXpress, an online brokerage firm. "The sentiment when you're doing a covered call should be that you're neutral about the underlying security. "

One interesting twist on covered calls is that they can turn a non-dividend-paying stock into a dividend-payer, says Jim Bittman, an options instructor at the CBOE.

Say you own 200 shares of Cisco Systems Inc. which doesn't pay a dividend. Sell one covered call, representing half of your position. If the stock goes sideways, the premium counts as income. If the stock rises past the strike price and the option is exercised, you'll still have 100 shares.

"When you sell a covered call, there's an obligation to sell the underlying stock," Bittman said. "You have to be willing to sell the stock or you have to know where you might want to buy that call option back if the stock rallies above the strike price."

As a hedging strategy, you can buy what's known as a "protective put" option, which is an insurance policy against a downturn in a stock you already own.

The strike price of a put is the exercise price at which you'll sell the stock. Puts are more costly in volatile markets like now, when insurance is on everyone's mind. The right to sell your Intel shares at $25 in October, for example, will cost you about $75 now. That means your break-even point is $24.25 a share -- the strike price minus the premium -- or 3% on the downside. If Intel trades below $24.25 in October, and you can sell the stock for $25, that $75 premium will have paid off.

"If you're confident about the future, buy a stock and take all the risk of owning a stock," Bittman said. "If you're more worried that the bull market might be ending, you could limit risk with options just like a homeowner limits risk by buying insurance."

What to watch out for:

Choosing a broker

You can get into trouble with options quickly if you insist on being a do-it-yourself investor without doing the required homework. Plenty of deep-discount brokerages will be glad to take your money. "People have a tendency to overestimate their expertise and knowledge," said Frederick, the Schwab strategist.

It's better to sign up with a brokerage that, while maybe not the cheapest, can connect you with options experts, such as you'll find at Schwab, E-Trade, TD Ameritrade and OptionsXpress, or a major Wall Street firm.

Trading near expiration

An option has value until it expires, and the week before expiration is a critical time for shareholders who have written covered calls.

Timing is everything. Keep a close eye on the calendar if those options are in the money, Frederick says. The stock could be called before expiration. If you want to keep your shares and at least part of the premium, buy the option back before that happens, he adds.

With a protective put, time is working against you as expiration looms. If the stock hasn't moved down enough, you might decide to sell that put and forfeit some, but not all, of your premium.

Dividend-paying stocks

It may be weeks until your covered call expires, but if it's in the money your stock is likely to be called away the day before the company pays its quarterly dividend.

"If you sell a covered call, be aware of when the dividend is going to be paid," Frederick said. "Either make sure you don't sell an option that expires after the ex-dividend date, or buy that (in the money) option back a couple of days before the dividend."

Market conditions

"There isn't one strategy that works in all market environments," said Cusick, the OptionsXpress analyst. Whether you're bullish, neutral or bearish about stocks will guide your options investing decisions.

If you're bullish and more speculative, for instance, consider buying calls on stock you don't already own. Factor in broad-market volatility using the CBOE Volatility Index , which measures the expected near-term volatility of the Standard & Poor's 500 Index .

Also, Cusick says, comparing the time remaining on the option with a stock's historical volatility -- the OptionsXpress Web site, for example, has a gauge of recent price activity -- can give clues into the stock's potential to fluctuate.

For income-oriented investors looking to write covered calls, higher volatility equals a larger premium. But there's also a greater possibility that a stock will have big price swings that could go against you.

Keep a short-term perspective and book the income quicker, Cusick says. "You're going to generate the most income with options that have the shortest amount of time left in them," he added.

Misusing leverage

"Options are not easy money," said Mike Burnick, editor of Marketshocktrader.com, an investment newsletter. "Options are great because they give you leverage to the upside, but it's a risky game. You're going to take total losses at times."

Investors using options more speculatively must have self-discipline to limit potential losses, Burnick warns. If you decide to invest $5,000 in S&P 500 options instead of an exchange-traded fund, for example, don't buy $5,000 worth of S&P 500 calls. Consider the leverage involved and buy the equivalent of a $5,000 investment in an S&P 500 fund.

"Regardless of how bullish you are," Burnick said, "you have to stick with your money-management skills and not invest more than your limit."

[StevenAnderson]

Penny stocks are available easily in the market and you can own them easily as common stocks.