Give Yourself Time to Be Right

Give Yourself Time to Be Right
by Ken Trester 09/29/08

In options, not understanding risk can empty your bank account faster than a 400-pound man emptying a buffet.

Risk is everywhere on Wall Street, but you needn't simply accept it. Instead, you can conquer it with stock options.

Contrary to popular opinion, option trading is actually quite easy. In fact, I can prove that you already know how put options work. How? Well, because you likely have car insurance, which is essentially the same thing as owning a put option.

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You see, the insurance policy protects you against loss of your vehicle, and the inputs that go into pricing the put are virtually the same as those that go into pricing your car insurance.

Look at it this way; the car is like a stock. You've got a lot invested in both, and you'd like to protect them should either get into an accident. How long you elect to protect the asset is the term -- or, in options parlance, the expiration month.

The deductible describes how much loss you are willing to take before the insurance kicks in. If you want zero-deductible insurance, you will pay more than if you want a $500 or $1,000 deductible.

The same is true for puts, as the at-the-money put (i.e., if the strike price equals the current market price of the underlying security) is a zero deductible and a $5 out-of-the-money put (whose strike price is below the current market price of the underlying asset) kicks in after your stock has fallen by $5.

The premium is, of course, how much you are paying for the protection.

'Call'-ing the Odds in Your Favor

Call options work the same as puts, except they give the owner the right to buy -- not sell -- the asset. Donald Trump routinely uses options on real estate to speculate and accumulate properties. He doesn't buy one single building; rather, he buys an option to purchase several buildings in the area at an agreed-upon price. And then, when he's got the block under control, he exercises his right to buy and then he builds his newest tower.

The building here is like a stock.

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How long you elect to have the option to purchase the building or stock is the term.

The premium is how much you are paying to the building owner or market makers in the option for the right to buy at a set price.

Option buyers frequently complain that they don't seem to win (i.e., make money) as often as they should. This may indeed be true, but the reason isn't because the pros have conspired against them; it's because they've stacked the odds against themselves!