Zen in the Art of Options

Some-many-like to play it safe in the financial world. These like to entrust their once and future wealth building to money managers or to very stable, low-yield financial instruments such as money markets and high grade bonds. These people feel that they don’t have the time or expertise to make “sophisticated” investment decisions for themselves, and in harmony with this they are extremely risk-averse.

There are others who likewise play it safe in the financial world, but according to a different strategy. These are people who carefully watch and choose individual stocks, such as those recommended by the newsletters of The Motley Fool; and indices, such as Spiders. The strategy in their minds is to analyze the individual companies and market sectors that they hold stock in while taking the Tortoise’s Buy-and-Hold Approach to Wealth Building-i.e., they plan on being millionaires in 25 or 30 years by building their wealth very, very gradually.

There is nothing mentally wrong with these people. They’re not goofy day traders, after all, or people who are afraid of even being in the game (remember-best way to avoid wealth is, no be there). These people have defined strategies and game plans.

But…there is a third strategy for making money via investments. This third strategy is growing steadily in its broad appeal. This third strategy is this former financial adviser’s personal recommendation.

This third strategy is called Options.

In the popular mind, stock options are extremely risky, overly speculative, and not even fit to be tried by anyone who isn’t a full time, experienced investing professional, or some kind of mutant economic genius. But nothing could be farther from the truth. The volume of trade in stock options contracts certainly would not be steadily, and now explosively, rising year after year since the mid-1990s if the participants were losing money on them.

So, what are options not?

To begin with, they are not outrageously nor even unduly risky. These aren’t undervalued companies. These aren’t small caps. Most options contracts are offered by Fortune 500 companies, and all of them are scrutinized and guaranteed by the Options Clearing Corporation. In addition, many options contracts are inexpensive to buy (often even less than $100 per contract). One options contract equals temporary control of 100 shares of a certain “underlying” stock; as I write this, I own an options contract that cost me $65 for control of 100 shares of a stock that was trading at nearly $60 per share if bought individually! The average price range of options contracts is $150-$200 a piece.

What precisely is an options contract?

It is a privilege, sold by one party to another, that gives the buyer of the contract the right, but not the obligation, to either buy or sell a stock at a price agreed upon in advance, anytime during a certain period up to and including a specific date. (There is a type of options contract called a European Option which can only be redeemed on the end date of the contract, but most options contracts are American Options and that is the kind I am writing about.) The privilege to buy stock is known as a call, and the privilege to sell stock is known as a put. The price that is agreed upon in advance (that is, at the time of the purchase of the contract) is known as the strike price. The money that is paid up front to purchase the options contract is called the premium. The 100 shares of stock underlying a contract are all shares of the same stock, such as Pepsi or Merck stock. All options contracts have an expiration month. This tells you when you will run out of time to exercise your option or sell your contract. An options contract expires the day after the third Friday of the expiration month. Holding an options contract beyond this date means it expires worthless, and you have lost whatever premium you paid to hold it in the first place. (This is not necessarily a bad thing.)

The strike price is of utmost importance. As the buyer of an option, you want the share price of the underlying stock to move past that strike price. If you have a call, then you are hoping the share price shall move higher than the strike price. If you have a put, then you are hoping for the share price to move lower than the strike price.

What an options contract gives you as an investor is great leverage. Due to this leverage, your fortunes do not have to rise and fall as the market rises and falls. As long as you position yourself in the right way, you can make substantial amounts of money even when the market is down. More importantly, you can use options to generate income. In fact, as miraculous as it may seem, using options to generate income is the least risky way of investing in them.

There are some basic, elementary methods to keep you from going mad when buying options…

Be patient. Good things come to those who wait. Do not invest all of your set-aside money right away. Have a year’s investment budget planned out in advance, and wait until you see those options that really look good to you before buying them These shall not come along every single day. Diversify. Always try to hold positions in both calls and puts and in more than one industry. In my opinion, the least risky way to hold multiple positions is by using covered calls. You should further minimize risk by paying as little as possible for each contract. Pay attention to the premium on a contract. And, make sure that your broker is a discount broker or has given you a discount on commissions. If that’s not the case, then get a different broker. Do not enter into a “managed options account”. Have a plan. Look at the stock price charts of a company as a guidepost for developing an idea in advance of when you will want to consider taking profits or closing out your position. When in doubt, seek out the advice of already-successful options investors. Do not seek out the advice of your broker, ever. Do not ever “go for broke”. When picking options, handle with care at all times. Invest slowly, and make money quickly. Only buy options using your risk capital. Seek major leverage. Do your best to buy options that you feel shall increase in value by at least 100%. Buy options on high volatility stocks. Since your time to work with is limited, volatility is your friend. Buy out of the money options. That is, buy options that would be worthless if they expired today. Whenever possible, buy options that you feel are undervalued. And at long last, be patient again. Investing in options is not day trading. Just because you have limited time doesn’t mean that you have no time.

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