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Author: 1000 Big funky green star, 20000 posts Top Recommended Fools Feste Award Nominee! Coverage Fool Supernova Phoenix 1
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Subject: New Option tutorial page Date: 11/27/2001 6:44 PM
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Hi Collective and Wax,

Here is hopefully, an improved tutorial to help everyone understand our option trades. Feedback and questions will help me further improve it. See questions are good!

Hi Wax and Collective,
I used a former post and made some changes to help everyone understand how are option strategy works and to act a review for those that might have forgot how it works.

I am not sure what is the best way to explain how options worked through writing. It is far more difficult to explain throught writing than it is if you were here in person. It is sooo easy to explain this to someone right by the computer with me. But I will try to make my explanation more clear. And if this does not help, I will keep improving it till it is clear.

I felt to understand how to write or sell options, you needed to know what it meant to buy them. By learning the fundamentals well, the other option concepts will come easily. A look at the CBOE site at www.cboe.com has many option tutorials.

I found Wade Cook's “Wall Street Money Machine” to offer a very simple explanation of writing options. Wade Cook is more into buying options and trading options which is very risky and is the last thing we want to do. As David brought out this becomes more like gambling. Buying leaps can be a good way to leverage your buying power, but it too carries the huge risk of buying a wasting asset. A wasting asset being one whose value declines with the passage of time. I seldom use this strategy, but if I do its with fun money. Writing options on the other hand is very safe and I use this strategy monthly.

By the way, you can usually buy a copy of the “Wall Street Money Machine” on Ebay without spending too much money. Generally for less than $7.00 including shipping. But if you ask questions I am sure you can learn how this works without buying the book. The hardest thing for me is, I am in the dark as to what part of options you do not understand. For instance, if you do not know how to look up the price of an option on Yahoo or CBOE than this would make it very hard for you to understand how the rest works. Option prices are listed just like stock prices on Yahoo. Just look up the stock symbol and you will be presented with several alternatives -- profile, snapshot, Options etc. Click options and it will list all the options available for that stock. So, if this part is not understood let me know and I will explain how to look up the prices etc. If you do not understand this part let me know and I will be glad to walk you through this step by step.


Remember ask all the questions you want that is the best way to learn!


Back to basics:

Equity securities are stocks issued by a company to raise capital for growth and expansion. Once issued, they trade in the marketplace at prices that change depending on the investor's perception of the company's future. Siebel is the equity security or stock, I will use as an example to explain different uses of options throughout this post.

Stock options are totally different from stocks. They are not issued by the company nor do they provide capital for the company. It may be best to think of options -- all options -- as contracts between two individuals. An option gives one individual the right, but not the obligation to buy 100 shares or sell 100 shares of stock at a specific price -- strike price -- before and up to a specific time known as the expiration date.

A strike price is the price an option could be exercised. On lower price stocks, the strike price will be set in $2.50 increments. For higher priced stocks, the strike price will rise every $5.00, and the strike price will rise every $10.00 for the very highest priced stocks. No option will be written for stocks under $5.00.

Options are not for everyone, but I feel each investor should have at least a basic knowledge of options. Why? Because
there are theories that suggest short term price movements can be predicted with some degree of accuracy by monitoring put/call volume activity. But that is not the main reason for learning the basics about options.

But the main reason to obtain knowledge of options use, is they allow investors to insure their portfolio against loss in much the same way a person buys insurance to protect his house from loss by fire or theft. This strategy is not for everyone and is more useful for those who have large stock holdings, and are nearing retirement, and wish to maintain a certain portfolio value amount.

Another interesting use of options is buying Leaps which allow a person to leverage his buying power. I do sometimes use this because its relatively safe and rewarding when bought as the market corrects. The NASDAQ crash makes Leaps look very good now. But I do not consider it a safe strategy for everyday use. Still understanding how leaps work creates a tool that can be useful in responsible hands.

Writing options though, I consider both safe and a good way to hedge your portfolio in rising markets, to obtain a company at a lower price, repair damage in a portfolio, and bring in income from one's portfolio.

The best part is the strategy is safer than buying stocks. The strategy also caps your upside potential if used with all of your holding or cash.

For me, the most important uses of options are giving one the ability to purchase a stock at a lower than present price -- the same way we are attempting to buy SEBL -- repair mistakes, and build positions in stocks safely. Options can also be used to increase cash flow from your portfolio. By using Leaps -- Calls or puts written with expiration dates over 1 year -- one can benefit from stock movements without investing the large amount it would take to buy shares of stock. A leap will control the profit element of 100 shares of stock, but at a fraction of the cost. Of course, like all options, a leap has an expiration date and at some point will expire. If you are unable to sell the leap at a profit by expiration, you will lose your entire investment. Of course, when things go against you, you can just like stock, sell the leaps for a loss exiting the position.

We will not be concerned with the buying of options, but we still should understand how they work. By understanding this, we will better understand what it means to write a contract or sell an option to open a contract.


What is a call option?

When an investor buys a call option to open a position this gives the buyer the right, but not the obligation, to buy the underlying security at a specific price for a specified time period. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy. The seller of the option is essentially being paid a premium to hold a 100 shares that he is willing to sell at the agreed strike price. Since the Collective is writing puts at this point in time, I will explain further in the next paragraph.

What is a put option?
An investor who buys a put option to open a position, purchases the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell.

In the case of the collective, Sebl is the underlying security. The specified time for us is Novemeber expiration date. All options expire the same time each month -- the Saturday following the third Friday of each month. In November, the date of expiration is November 22. So, if an investor buys an option or if he writes an option on August 10th, 2001 with a November 01 expiration and then buys or writes another option on September 11, 2001 also with a November 01 expiration both contracts will expire on November 22, 2001.
Sebl option buy report
http://boards.fool.com/Message.asp?mid=15514457
Wrote 1 Nov 32.50 put option.
Premium 100 x $4.10 = $410
Commission $28
Net premium to be added to the FC RM Port = $382

What happened in the above portfolio example.
Basically, it was decided that Sebl was worth buying at 32.50 especially with a $382 cushion. So, the Collective wrote a Nov 32.50 put on SEBL.

What did this mean.
We sold a put to open a contract. This means we did not own the put. We had never bought that put. We opened a contract with an unknown buyer of the put which could have been an individual or the brokerage house itself. We were immediately paid after commission $382. If Sebl had stayed above 32.50 by November expiration -- Nov 17, 2001 -- we would not have had to buy the stock, but we would have still kept the $382.

Ahhhhhh!!!! But it didn't! It went down Waaaayyyyyy down. So on November 18, 2001 we were assigned 100 shares of SEBL at 32.50. We still keep the $382, so our cost basis is $32.50 - $3.82 = 28.68.

Now we have decided from the way Siebel collapsed and subsequent news that perhaps even this price was a mistake. We now are in the process of correcting that mistake by selling calls on shares we bought lower to reduce further our cost basis on our entire position. Since we have wrote calls on the entire position, we do cap our upside but if called away we go out with a profit. We can then build our position in Sebl slower by selling puts again on SEBL, but at a lower price. We will plan this as we go.






What if there were no buyers?

We sell a put what if there is no buyers?
Then Brown & Co would have become obligated to provide the liquidity by taking the other side of the contract. In other words, they would have had to buy the put. This is similar when you sell shares of stock. If no one, at that time, wants to buy your stock, the brokerage house is obligated to buy those shares till a purchaser can be found. In the meantime, those shares go into the brokerage house's inventory.

Ok Let's look at some terms

Investors can buy an option to open a contract. As an example, someone could buy a put to open a contract. This is much the same as someone buying a share of stock, they call their broker and say they want to buy 100 shares of Seibel and it is executed. A buyer of a put will do the same thing. They will call their broker and say I want to buy a put. Let us use the SEBL November 01 $32.50 strike price and let us say they paid $450 for that put. Those who would buy a put on SEBL, in this case, believes that Sebl will go down over $5 points by November expiration -- for them the further down it goes the better -- they can then at some point sell the put for more money than they bought it. If Sebl goes down as far as 22.50 the holder of the put would be able to collect $10.00 per share or $1000 plus any remaining premium minus commissions. They can now sell the put to close their position or contract and collect their profit. In this example, the buyer of the put did not have to own 100 shares of the stock, yet could profit dollar for dollar for each dollar move down the underlying stock moved minus their initial $450 paid for the put and commissions. This transaction is exactly like an investor who buy a 100 shares of stock then sells that same 100 shares for a profit. The advantages of doing this is, buyers of options can with less money control the profit element of a 100 shares of the underlying security or stock minus the time decay. The disadvantages, the put is a wasting asset and will decline to zero with the passage of time even if the stock remained stable in value. In order to profit, the buyer of the put must see the underlying stock go down in value and at a faster rate than time decays the premium on the put.


Next term

Selling a contract to open a position or writing an option

This is the strategy the Collective will use -- it is relatively safe and time decay is actually our friend not an enemy like it is with the buyer of a put or call.


This is very different from selling a put to close a position which is what transpired in the above example. In this case, the seller of the option initiated the sell without ever owning the option. This was a very hard point for me to understand, when I started learning about options. I could not understand how I could sell a put I did not own.
I knew only that you could sell stocks if you first owned them. In the case of selling puts to open a contract, you do not own them first. You can actually sell a put although you do not own it -- called selling a put to open a contract. It is also called shorting a put.

Terms that mean the same thing:
Selling a put to open a contract
Writing a put
Shorting a put
These terms all mean the same thing. It means one is selling a put to open a contract. It means that one is not selling a previously owned put.

You can also sell stocks without owning them -- that is called shorting a stock. For instance, if you wanted to sell 100 shares of SEBL but you did not own any shares of SEBL, the brokerage house would still sell 100 shares for you. This is called shorting a stock. When we sell a put to open a position we have shorted that put. It will show up as, one SEBL 32.50 Nov 01 put short position on your brokerage statement. The Collective actually shorted one put on SEBL and may be planning to short another soon. As it turned out we did at a much lower price strike 17.50 if memory serves me correctly.

Terms on valuing options.


Strike price -- I think we understand this one now. It is the price an option can be exercised at, prices which are set at each $2.50 $5.00 $10.00 increments which depends on the price of the stock. Higher priced stocks will have strike prices set at larger increments.

Option, both puts and calls, are said to be at-the-money if the underlying security -- Sebl for instance -- is selling for a price equal to the strike price they were contracted at.

A call is said to be in-the-money if the price of the underlying security -- Sebl for instance -- is selling for a price greater than the strike price it was contracted at.

A put is said to be in-the-money if the price of the underlying security -- Sebl for instance -- is selling for less than the strike price.

A call is out-of-the-money if the price of the underlying security -- SEBL for instance -- is less than the strike price it was contracted at.

A put is out-of-the-money if the price of the underlying security -- SEBL for instance -- is greater than the strike price.

The above five statements may seem unimportant but it is how options are valued and will help you understand intrinsic value of an option. Intrinsic value is the most important fact you will want to know about option pricing, because it is the money you will receive at expiration if you decide to close your contract for buyers of options or the price you will pay if you decide to buy back your contact for writers of options. For instance, if SEBL is selling at $32.50 the options bought at that $32.50 strike are at-the- money and the intrinsic value of all options is zero and any money you receive is premium. If you were to buy a call at that strike when SEBL shares were selling above $32.50 on an expiration date of November the entire amount you pay would be the premium there is no intrinsic value. If Sebl shares are selling at $32.50 there is no premium or intrinsic value at expiration. It is a total loss. Writers of calls would be the only winners here.

Definition of intrinsic value:

Intrinsic value is the options real value right up to the last second till expiration. Remember when options expire they are worthless. Intrinsic value is dollar for dollar equal to the amount the option is in-the-money. For instance, if SEBL is selling at $32.50 and the option you purchased is contracted at $32.50 that option has no intrinsic value, all of its value is in the premium.

The premium will go down as we approach expiration. It is a wasting asset or the value diminishes with the passing of time. However, the intrinsic value depends only on the movement of the stock -- the passing of time has no effect on it. For instance, if we paid $750 for a Sebl call, when SEBL was selling for $32.50, the intrinsic value was 0 and the premium was $750. If SEBL stock goes to $42.50, the $32.50 strike call would then sell for $1750 if no time has passed. The intrinsic value would be $1000 and the premium part $750.

However, so you don't get confused when discussing premium, many will correctly consider the whole $1750 as the premium paid. But premium is also used to describe the part of the cash paid for an option that goes down with the passing of time as we draw closer to expiration. Again, For instance, let us say that November approaches and the price of SEBL stays at $42.50, then the premium or diminishing part of the option value will decline to near zero. One second before expiration the price of that same SEBL call will be $1000 -- its intrinsic value. At that point in time -- one second before expiration -- you can still sell that call for $1000.

On the other side of the coin, if SEBL is selling for 30 dollars by expiration -- $2.50 below the strike price-- that call will have no intrinsic value nor premium value it is worthless. It is worth zero.

I think it would be best for everyone to read over the above carefully and ask questions if it not easily understood, as I can probably simplify the answers to the questions better than trying to simplify each of the above statements. The above should provide a good guide to form questions if it is not fully understandable, as I can refer back to this page when answering them. It is a new subject and it is not really complicated once you see how it works. But because it is a new concept for many people it will seem horribly complicated, I remember how I felt when my friends were trying to make me understand it. It was very difficult for me, but once I learned it I felt like Homer Simpson when he says "DOH". I had to ask tons of questions to understand it. So ask all the questions you want.

tom
History of buying SEBL at the Collective
http://boards.fool.com/Message.asp?mid=16168746
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