A Fast Course
in Options
A Fast Course
in Options
Oh, NO! Not Options
For more information:
by Franklin Sanders
The Moneychanger
That's
what many -- if not most -- investors scream whenever I begin talking about
options. "I can't understand them," they always complain.
Look
-- I'm a compassionate fellow; I have children. I like (some) dogs.
I
understand. You have to spread a little mental elbow grease on the subject
to grasp it. How's that for mixing up some metaphors?) Okay, big deal. Everybody
has to think a little. I admit, it's not TV, but it also isn't beyond people
of normal intelligence. I know readers of The Moneychanger and The Bull
& Bear are head and shoulders above the ordinary investor, so for you,
understanding options will be a snap! Just trust me and keep on reading.
Ask
yourself: If somebody told you how to control an investment worth thousands
of dollars for pennies on the dollar, would you be interested? Can a duck
swim? Is a pig's leg pork? Of course you would. Well, that's options, so
read on.
An Example
Suppose
your brother-in-law calls one day and whispers into the phone, "Pal,
I just talked to Representative Kickback on the state legislature's Highway
Building Committee. He told me they're going to put in an interchange on
Interstate Zero right at Winchester Road. Nobody else knows about it, so
we can buy that land. We'll make a fortune!"
You
race through your mind adding up all your assets: $1,000 cash and 89¢
in assorted change. You know the property. It's ten acres priced at $2,000
an acreno way you can raise $20,000 that quick. A light bulb flashes in
your mind: I'll option the property!
You
call the property owner and offer him this deal: sell me an option to buy
your property at any time within the next six months (the "expiration
date") for $4,000 an acre (the "strike price") and I'll pay
you $100 an acre, a thousand bucks, right now for the option. If I don't
exercise the option, you get to keep the thousand bucks."
The
owner says "Okay, bring me the thousand bucks (the "premium").
You're in business.
Sure
enough, your brother-in-law's tip pays off. Two weeks later the state announces
a new exit off Interstate Zero at Winchester Road, and the value of the
property soars to $8,000 an acre. You exercise your option, buy the land
for $4,000 an acre, and sell it for $8,000 an acre to a developer who wants
to put up a fried chicken joint, a beauty salon, and a gas station. You
pocket $3,900 an acre ($4,000 an acre x 10 acres) -- $1,000 for the option
= $39,000). The developer is happy, and the owner gets twice as much as
he though the land was worth. You make 3900% on your option investment.
It's such a great deal you even give your brother-in-law a hundred bucks
for calling you with the tip. (No point to give him any more -- he'd just
drink it up anyway.)
And
that is only part of how you can make money with options.
Options
Options
grant you the right but not the obligation to buy (or sell) a stock,
commodity futures contract, or group of stocks comprising a stock index
at an agreed price ("strike price") at some specified date. There
are also very long-term options, LEAPS (Long-term Equity AnticiPation Securities).
Options
which grant the right to buy are termed "call options."
If you want to go long, you buy call options. If you want to go
short, you sell call options.
Options
which grant the right to sell are "put options." If you
want to go short, you buy put options. If you want to go long,
you sell put options.
The Rewards
Why
would anybody buy options? Chiefly because they can limit your risk.
Whether you buy calls or puts, what's the very worst thing that can happen?
The option expires worthless and you lose the entire premium (the price
you paid for the option.) You will never get a margin call because you bought
options (not true for selling options). No truck will come to your
front door and dump 50,000 pounds of unwanted pork bellies on your porch.
Options,
however, carry a time value. When you buy an option, you are really buying
time. Other things being equal, the closer the option comes to its expiration
date, the more quickly its value falls.
Options
offer great leverage. That means for three or four cents on the dollar,
or less, you can control a huge investment and shoot for huge profits. Because
you know the risk of options in advance (the entire premium), you can use
them very efficiently to manage risk.
You
can also hedge with options. Suppose you are long 100 shares of GM
at 75, and it rises to 95. You think GM may rise to 105, but you don't want
to risk your profit while you're waiting. You buy the put option,
i.e., the right to sell, with a strike price of 95. Now if GM goes
to zero, you can still sell at 95. If it goes to 105, you keep the stock
and let the option expire worthless. Sure, you're out the little cost of
the option, but that's the cost of insurance. When you buy life insurance
on January 1st, do you complain if you're not dead by December 31st?
Or
suppose you want to buy GM at 95, but won't have the money to buy
it for three more months and are scared it will soar. You can buy a call
option with a strike price of 95, and lock in the cost of your GM stock
for pennies on the dollar. If GM doesn't rise, you're only out the cost
of the call.
Earning Income
You
can also use options to earn income or lower your investment costs. Suppose
in our example above you own GM stock, and intend to hold it forever, or
until it reaches 95. You aren't sure it can make it. You can sell
a call option. If the stock goes to 95, the stock will be called away
from you, but that's okay, because you wanted to sell it at 95 anyway. If
the stock goes to 35, nobody will exercise the option at 95, and you get
to pocket the premium. This earns you income while you are holding the stock,
and also offsets losses. This is called "writing covered options"
because the call options you sell are covered by the stock you own.
If
you don't own any GM stock, but you want to bet that it will not exceed
95 bucks before the option expires, you can write a naked call option.
It's called a naked option because you write it without any covering.
Index Options
These
are options on various stock indexes. The underlying value of these options
is determined by multiplying the index value by some number, usually $100.
Strike prices are set at certain intervals. Exercise style is European-style,
so options may be exercised at expiration only. When exercised, index options
are settled by cash (the cash value of the underlying stocks), not
by handing over the shares of the various component stocks.
Gold/Silver Stock Index
You
can also buy an option on the Philadelphia Gold/Silver stock index. This
is a weighted index of seven major mining shares. It offers a way to participate
in the entire mining sector.
LEAPS
LEAPS
is a trademark of the Chicago Board Options Exchange (CBOE). These were
first offered by the CBOE in 1991 with two year LEAPS on 14 blue chip U.S.
stocks. LEAPS were a fast hit. Today you can buy LEAPS on 136 stocks and
many stock indexes.
What's
the benefit of LEAPS? Time -- more time than the three month life
span of most options. And more time means more time for you to be right.
If you are interested in LEAPS, you ought to buy the books, LEAPS: What
they are and how to use them for profit and protection by Harrison Roth
($60, McGraw Hill Companies, 1-800-722-4726). The investment strategies
possible are almost endless.
Options On Futures
When
you hear about "gold options" or "silver options," the
terms actually mean options on futures contracts. The option actually guarantees
you the right, but not the obligation, to buy a gold or silver futures contract
at a certain price. Gold futures options are for 100 ounces; silver futures
options for 5,000 ounces.
Hedging Your Physical Gold And Silver
These
are the options I have discussed previously to be used as a hedge for your
gold or silver holdings. What if Y2K fizzles? There may be a passel of disgruntled
gold and silver owners selling in January 2000 (then again, there may not,
if economic problems have driven up the price of gold and silver). Problem
is, you can't know beforehand whether Y2K will fizzle or sizzle, and you
don't want to sell your physical gold and silver before the fact.
In
the fall of this year, we will want to buy gold or silver put options
to hedge our physical holdings. Options can stand in three positions against
the current market price:
Obviously,
the out-of-the-money options are less valuable than in-the-money options,
because they have no intrinsic value, only the speculative value that the
market will rise or fall before they expire and thus give them value. This
works to our advantage if we are trying to hedge a position cheaply.
How Many Should You Buy?
We
can't know in advance what the cost of out-of-the-money put options will
be next fall, but here's a theoretical example to show how our hedge should
work. Suppose next fall that gold is selling at $375 an ounce. You bought
your physical gold at $290, and now you have a nice paper profit -- paper,
because you haven't yet cashed in. You want to hold the physical gold in
case Y2K wipes out the banking system, but you don't want to risk a huge
drop below your $290 purchase price. What to do?
Suppose
that out-of-the-money put options with a strike price of $325 are selling
for $100. You own 50 ounces of gold, so you buy one put option (which actually
cover 100 ounces). Several things can happen:
One
of the imponderables here is the changing value of an out-of-the-money option
as the market slides. It will become more and more valuable as it gets closer
to the in-the-money position, but how rapidly no one can say in advance.
Once the option gets in-the-money, it participates dollar for dollar with
any rise or fall in the market price of gold, so from the time that your
option goes in-the-money, it covers you ounce for ounce. Because you are
buying out-of-the-money options with a strike price below the current market,
you will want to buy more put options than you have ounces of gold. In our
example above, with 50 ounces of physical gold, you buy one 100-ounce option.
It will not cover your holdings for the drop from $375 to $325, but below
$325 it covers two ounces for every one-ounce you hold. How many options
we will buy will depend on how much the out-of-the-money options cost at
the time, and how much gold or silver we are holding.
What About High-Premium Gold Or Silver
High
premiums on gold or silver items must be factored into our purchase decision
as well. If, at the time you buy options you hold, for example, US 90% silver
coin, and that coin is trading at 200% of its silver value, you should buy
enough options to cover the entire equivalent in ounces. Say silver is at
$10 an ounce, and you hold seven bags of 90% coin containing a total of
4,290 ounces of pure silver (715 ounces per bag). But the bags are trading
at $14,300 a bag, twice their silver value, so you need to buy enough
options to cover twice as many ounces as you physically hold. In this case
you would buy two 5,000 ounce put options to cover the value of the silver
and the premium on the bags.
Likewise,
if you hold any physical gold which has acquired a high premium, you should
buy enough options to cover both the gold content and the premium over the
gold content.
Who Should Buy Options?
This
is a matter of your risk preference, but anyone who has invested $15,000
or more in gold or silver should strongly consider buying put options next
fall. If you have bought $30,000 or more (roughly 100 ounces of gold or
5,000 ounces of silver) you definitely should take out this insurance.
In
the end, none of us has a crystal ball. No matter how bad you think Y2K
will be, you ought to think long and hard before you carry the risk of a
large gold and silver position without any insurance. Cheap out-of-the-money
gold and silver futures options are the only way I know to hedge your holdings.
Your
stock broker cannot sell you commodity futures options. You need a commodity
broker for that. My friends Sue Rutsen and Teddy McAleer have many years
of experience. You can contact them at Fox Investment in Chicago (800) 621-0265,
and order a copy of their very helpful booklet, A Short course in Futures
& Options. I have no financial interest in this recommendation.
Editors
Note: © 1999 Little Mountain
Corporation DBA The Moneychanger. All rights reserved. May not be reprinted
or republished in any form without publishers written permission. Franklin
Sanders is editor of The Moneychanger, published monthly by Little Mountain
Corporation. Yearly subscription rate is $95. Bull & Bear readers who
mention this article can subscribe to The Moneychanger for $95 and as a
Special Bonus will receive a FREE copy of Franklin Sanders manual, The Gold,
Silver, & Platinum Reporta $49 value. Send payment with order to The
Moneychanger, P.O. Box 236, Cordova, TN 38088-0236. Visit the Web site at
www.the-moneychanger.com.
|| TABLE OF CONTENTS || Bull & Bear Newsletter Digest || Bull &
Bear Reporter Featured Companies || Monetary Digest |
| The Bull & Bear Financial Report Copyright 1999 | All Rights Reserved Reproduction in whole or part is strictly prohibited without prior written permision NOTE: The Bull & Bear Financial Report does not itself endorse or guarantee the accuracy or reliability of information, statements or opinionsexpressed by any individuals or organizations posted on this site PLEASE READ DISCLAIMER |
Web Site Designed & Maintained by Estrada Design & Communications in association with THE BULL & BEAR INTERNET DIVISION |