ISSUE 4

Options 101
By Bernie Schaeffer, Founder, Chairman and CEO, Schaeffer's Investment Research

What does the word options mean to you? To many, the word conjures up an image of a high-risk, mysterious investment that is only for the reckless speculator or strong of heart. One of our primary goals at Schaeffer's Investment Research is to take the mystery out of options through various education programs to bring them more into the investment mainstream. With this in mind, allow me to introduce you to the potentially very profitable world of options.

Definition
An option is an instrument that allows you to buy or sell a certain amount of an underlying security. For our purposes here, the underlying securities will be stocks. A stock (or equity) option contract typically represents 100 shares of the underlying stock, even though they are commonly priced on a per-share basis. Thus, a stock option priced at 2 will cost an investor $200 per contract. An option buyer is essentially leasing the movement in the stock over the life of the option at a fraction of the cost of owning the stock.

Calls
There are two types of options: Calls and puts. A call option purchase gives you the right (but not the obligation) to buy 100 shares of a stock at a specified price (known as the exercise or strike price) up until a specified date (the expiration date). That is, the call buyer can exercise his or her right to buy the 100 shares of stock at the strike price at any time before the option expires. Buying call options is a bullish strategy initiated when a call buyer believes that the underlying stock will rise substantially in price over the life of the option. In essence, the call buyer is renting the price appreciation in the stock over the life of the option.

The concept of a call option purchase (also called a long call) can be illustrated by examining the profit or loss of a particular option strategy over a range of stock prices at expiration. Table 1 shows the possible outcomes of purchasing a 50-strike call for $5. (This option would cost $500.) This option gives the buyer the right to purchase 100 shares of the underlying stock (up until the option expires) at a price of 50, no matter how high the stock price goes. Note that the breakeven point (profit of zero) for this trade would occur if the stock reached 55 at expiration (the strike price of 50 plus the premium of 5).

Any stock price greater than 55 will result in a profit for the trade while a stock price of 50 or less will result in a total loss for the trade. Between 50 and 55, the buyer will incur a partial loss. (For example, a price of 51 would result in a four-point loss.)

Table 1 points very clearly to three important characteristics of this long call position: (1) a breakeven point of 55 (strike price plus the premium), (2) a maximum risk of 5 (note that the loss is constant at any stock price of 50 or less) and (3) theoretically unlimited profit because there is technically no upper limit to how high the stock price (and, thus, the value of the option) can rise.

As the stock moves above the breakeven level, the call buyer will profit on a point-for-point basis with each point move higher in the stock. Keep in mind that the risk for a call buyer is truncated (because the maximum loss is limited to the premium paid) while the profit potential is theoretically unlimited.

Table 1

Puts
A put purchase gives you the right (but not the obligation) to sell 100 shares of the underlying stock (by the expiration date) at the specified strike price. Put buyers are bearish on the underlying stock, believing that the stock price will go below the strike price before expiration. The put buyer is essentially renting the price decline in the stock over the life of the option.

Note that the put buyer achieves profits as the stock goes below the strike price, and losses occur as the stock advances above the strike price.

Table 2 is the profit-and-loss table for a put purchase (long put). Let's assume that a put buyer is bearish on a stock with a current price of 75 and buys a 70-strike put for 3 ($300 per contract). The breakeven point (profit of zero) for this trade is achieved if the stock falls to 67 at expiration (the strike price of 70 minus the premium of 3).

Any stock price less than 67 will result in a profit for the trade while a stock price of 70 or greater will result in a total loss for the trade. Between 67 and 70, the trader will incur a partial loss. (For example, a price of 69 would result in a two-point loss.)

From this, we can conclude the following: (1) the breakeven point is 67 (strike price minus the premium), (2) a maximum risk of 3 per share, or $300 per contract (note that the loss is constant at a stock price of 70 or more) and (3) a theoretical profit potential of 67, which is achieved if the stock falls to zero by expiration (highly unlikely, of course).

Note the difference between puts and calls: Calls have no theoretical maximum profit; whereas, a put's maximum value is capped at a stock price of zero.

Table 2

LEAPS
For those who remain wary of options, a compromise exists that provides a "bridge" between the realms of stock and options trading. Long-Term Equity AnticiPation Securities (referred to as "LEAPS") are either calls or puts with expiration dates up to 2-1/2 years in the future. Like standard equity options, a LEAPS contract represents 100 shares of the underlying security and is available as either a call or a put.

LEAPS offer both option and stock investors an excellent profit vehicle by allowing a big-picture trend on a stock to play out, with much less capital required compared to buying the underlying stock outright. Yet, LEAPS are less risky than their short-term options counterparts. For those who prefer a one-year to two-year time horizon for their investments, LEAPS offer an excellent alternative using options.

Why Options?
You may be thinking to yourself, "Well that's all well and good, but why should I trade options?" I believe that options, when used properly, can enhance the performance of almost any investor's portfolio. Three main advantages make options attractive as an investment choice.

1) Limited dollar risk and limited dollar exposure
As an option buyer, you benefit from being able to control the movement in a stock for just a fraction of the cost of purchasing that stock. Plus, you can never lose more than this modest dollar amount. As a result, you can keep the bulk of your investment dollars in the safety of cash where it is immune to the wild and often stomach-churning swings in the market.

2) Leverage
You can achieve percentage gains from your successful options investments that are five-fold, ten-fold and even greater compared to those achieved by stock or mutual fund investors. Because of this leverage, strong bottom-line returns can be generated with limited capital at risk.

3) Profit in Bull and Bear markets alike
This third advantage is at the heart of why experienced options traders have profited in the volatile market of the past year or so. By buying put options, you can achieve leveraged profits with limited dollar risk when a stock declines in price. What's more, compared to short selling, put buying has the advantage of placing fewer dollars at risk and capping losses at the initial amount invested. Of course, leveraged gains can be achieved on bull moves by buying call options.

Just in case you're still not convinced, The Options Industry Council (OIC) announced that option trading volume in 2000 set a new record for the ninth consecutive year. In fact, equity option volume on all U.S. options exchanges was an impressive 51 percent greater than 1999's record-setting pace. And, it continues to grow; volume increased 15.9 percent in the first quarter of 2001 compared to the same period in 2000. It's becoming quite clear that options are being more widely accepted as an important component of many portfolios.

Where to Find More Information
Obviously, I've barely scratched the surface of what options are and how they can be used. Numerous resources are available that can teach you everything you need to know about options and option strategies. My book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options, is suitable for the beginning and seasoned options trader.

Websites on options abound, including my award-winning SchaeffersResearch.com, the OIC's 888Options.com and cboe.com, the website of the Chicago Board Options Exchange. Whatever the source, I suggest you take a serious look at options if you're interested in giving your portfolio a boost. Once you understand what options are all about and how they can be used efficiently and safely, I guarantee they won't seem nearly as intimidating as you might have once thought.

Schaeffer's Investment Research began in 1981 when founder Bernie Schaeffer started publishing The Option Advisor monthly newsletter. As senior editor, Bernie's aspiration was to show traders just how they could discover profit opportunities in both stable and volatile markets. Now, as Chairman and CEO of Schaeffer's Investment Research, Bernie has led the monthly publication to success as one of the nation's largest circulation options newsletters. Bernie's approach to market timing has earned him a "Best of the Best" award from the Market Technician's Association, as well as a number-five market timing ranking from Timer Digest over the past decade.

For more information, contact:
Nicole Kessler
Schaeffer's Investment Research
Email address: nkessler@sir-inc.com
Website: http://www.schaeffersresearch.com/