Website design By BotEap.comYou’ve probably heard people refer to options as a risky venture, similar to gambling. And it is true that options trading can be very risky, especially when done with minimal knowledge and preparation. The average stockbroker or financial planner does not have enough knowledge of options to guide them in the use of options in their portfolio. But that doesn’t mean options can’t play a role in a conservative stock portfolio.

Website design By BotEap.comMost of today’s options trading volume comes from institutional money managers who use options to protect their clients’ stock portfolios. They are using options like insurance. Options can also be used to increase the income that can be derived from a conservative stock portfolio.

Website design By BotEap.comWritten options on stocks are called stock options and come in two forms: call and put. A call option gives the option holder the right to buy the underlying shares at the option strike price at any time before expiration. A purchase option is similar to a grocery coupon for a five-pound bag of flour at an attractive price; but the coupon is only valid for 30 days and is limited to the purchase of a five-pound bag. Similarly, a call option entitles you to buy 100 shares at a specified price and is only good for a set period of time.

Website design By BotEap.comPut options are the opposite of call options and are more like insurance; A put option gives the owner the right to sell the underlying shares at the option’s strike price at any time before expiration. Put options are often bought when one expects the price of a stock to drop, or could be used as a form of insurance if I already own the stock; If my stock price falls, my put option appreciates and offsets some or all of that loss. An excellent analogy is home insurance; If I pay my insurance premium on January 1st and nothing happens to damage my house this year, my insurance expires worthless, just as my put option will expire worthless if my stock continues to appreciate. But if a hurricane damages my home during the year, my insurance pays for some or all of the repairs. Similarly, if my stock price falls, my put option will increase in value, replacing some or all of the loss in my portfolio.

Website design By BotEap.comStock options expire on the Saturday following the third Friday of each month. It is common to hear or read that stock options expire on that third Friday. While that is not technically correct, it is true that Friday is the last chance to trade those options. The Saturday expiration was set to give the Options Clearing Corporation and brokerage firms time to settle their clients’ accounts before the options technically (legally) become worthless.

Website design By BotEap.comConsider the hypothetical company, XYZ, as an example. XYZ closed May 28, 2009 at $34.70; the June $35 call option was trading at $1.00 at closing. In option quotes on a site like Yahoo Finance, you’ll see the bid and ask prices posted. The Ask price is the quoted price if I want to buy the option, while the bid price is what I would have to pay to sell my option. Options are quoted per share of the underlying stock, but are sold as contracts covering 100 lots of shares. June $35 XYZ Calls are trading at an ask price of $1.00. Each contract is priced at $1.00 per share of the underlying stock; Since each contract covers 100 shares, one contract costs $100 and five contracts would cost $500. I have the right to exercise my options at any time before they are delisted on Friday June 19 and purchase 500 shares of XYZ at $35 per share or $10,500. Or I could simply sell my call options at the ask price any time before expiration.

Website design By BotEap.comOptions can be used in a number of very conservative ways in a stock portfolio. For example, if I own 300 shares of XYZ, but am concerned that this market is weakening and could fall again, I could buy three contracts of the June $35 put options at $1.40 to protect my position. This short position would cost me $420 and would protect me until June 19. As XYZ falls in price, the put options will increase in price, offsetting some or all of my loss on the stock. This is called a “married sell” position. However, there is no free lunch in the market; if XYZ trades sideways or up, I will lose my $420 “insurance premium”.

Website design By BotEap.comAnother conservative use of options is the “covered call” strategy. If we continue with our XYZ example and I think the stock will trade sideways or slightly higher over the next few weeks, I could sell three contracts of the June $35 calls for $1.00, bringing $300 to my account. If XYZ trades unchanged at $34.70 on June 19, the $35 call options will expire worthless and I will have earned $300 or 2.9%. But if XYZ trades above $35, my maximum profit is capped at $330 or 3.7%.

Website design By BotEap.comOptions trading can be very risky when used speculatively, but options can also be used conservatively with a portfolio of stocks, protecting downside and increasing portfolio income.