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Trading Options, Improve your Portfolio Management

Updated on May 24, 2011

For most, investing in a stock is intimidating enough, but assuming that you've already taken the plunge and manage your own portfolio, including options into your strategy is an extremely effective tactic to boost your earnings. Because the market moves in 3 directions, up, down or sideways, options provide the flexibility to invest with the trend regardless of which way the market is heading.

Options are broken down into Calls and Puts. Investments are typically described from a purchasing perspective, so if you were to buy a call, you would want the stock to go up. If you were to buy a put, you would want the stock to go down. An easy way to remember it....call up your friends....put down your enemies. A little more detailed, we tend to refer to a position that increases with stock appreciation as being "Long", while one that appreciates as the market decreases as being "Short". So in their natural position, a Call is Long, a Put is Short.

So why use options? The ability to make money regardless of the market trend and leverage are the primary reasons for using options. One option contract is equivalent to 100 shares of the stock or "underlying" and cost substantially less than if you were to actually go out and buy 100 shares. For instance, buying 100 shares of Google may cost you over $60,000 or you could control 100 shares for $2,000 - 3,000 through 1 option. So how should you use options? Options, when used responsibly can dramatically boost your investment returns. There are 4 primary times when using options make sense and can add value to your portfolio. 1) when you have current stock positions in 100 share increments 2) when the maket pullsback or in a bear market, 3) as a stock substiute for costly stocks and 4) to speculate. But before you buy an option you need to understand their pricing.

Options are priced by their "Strike" price and are either "in-the money", "out of the money" or "at-the money". A strike price is the price at which you control the stock. For instance a Microsoft strike price of $25 means you have the option to buy or sell the underlying regardless of what mircrosoft is currenly trading at for $25. If the strike price is below the trading price, it is said to be "in the money", if it is the same it is "at the money" and if it is above, it is "out of the money". Obviously you would pay more for a strike that is already "in the money" compared to those "out of the money". Determining which strike to buy depends on your objective.

Options are priced in monthly increments and expire on the 3rd Friday of the month. So an option for this November would expire on the 19th. Depending on your strategy, timing is very important. Time impacts the premium you pay for a given option. For instance, if you were to look at, "at the money" options of Microsoft for December and January, which as of today would be the 25 strike, you would see that December would cost you $1.20 and January $1.50 (keep in mind that 1 option contract is = to 100 shares) so this equates to $120 and $150 respectively. In this example, you are paying a 25% premium to hold the option till January expiration as opposed to December. Depending on your strategy, this may help you or hurt you. Different strategies require you to buy or sell options at different strike prices.

For stock positions you currently own, you can increase your earnings very effectively by using options. For every 100 shares you own, you can sell 1 call. This is known as selling covered calls. The calls are covered, meaning that you already own the underlying as opposed to naked, where you are essentially exposed to the liability of having to buy the shares to fill the option if it is executed. The benefit of selling calls is collecting the premium. To employ this strategy, lets walk through an example. Suppose you own 500 shares of Microsoft, that you bought at $24 a share. Based on its trading range, which over the past few months, MSFT has been trading between $23 and $27 a share you decide you want to sell the Feb 27 Calls (the 27 is referring to the strike price). The Feb 27 has a bid of .75, therefore selling 5 x $.75 will bring in $375 of premium income.

So how does this work? If by Feb expiration, MSFT is trading below $27 a share, you keep the stock and the $375. In some cases, it really is that easy to make an additional $375. A few things can come along that impact this strategy. If the stock goes above $27 a share, you run the risk of it being called away. Because you chose $27 as the strike for the call you sold, any gain over $27 was sold along with the call, so if MSFT is at $28 and your option is executed, you will miss out on the $500 gain ($28 - 27 x 500). As long as the price of the stock is trading below its strike, its likely the option will expire un-executed and you walk away with your premium. Theoretically, you can do this every month and bring in an extra $500 - $1,000 or more in cash a year, while still enjoying the dividend and market appreciation of the stock. The trick is to pick the right strike with the right amount of time.

Market pullbacks are a great time to employ options. After a run-up in the market, its inevitable that stocks will pull back. You can capture profits on this pullback by buying puts. This requires somewhat of a technical understanding, to be able to recognize when a stock is overbought, at its ceiling and about ready to run out of steam. But if you can identify this scenario, its pretty effective to capture money on the downside. Good candidates for this strategy are typically stocks that have broken out to new 52 week highs and are up to levels that seem unsupportable. For instance, Apple reached a new high of $292 back in September then fell back to $283, recharged and rallied to $318 in October, then fell back to $300, rallied to $320 in November and now sits at around $300 a share again.

You can see that these trends take about a month or two to develop, but if you're patient, you can time it right and capture the fall. And once it settles, go the opposite way and ride it back up with a call option. And if the stock becomes bearish, buying puts (the opposite of calls) is a great way to make money in a declining market. So even while stocks may be losing money, if you buy a put, it will increase as the market declines.

Using options as a stock substitute is another strategy to gain exposure to costly stocks. Apple is a great example of using options as a stock substitute. Not many people have $30,000 to invest on a single stock. But buying 1 option allows you to control 100 shares. Whats important though, is that you only want to buy deep, in the money calls. This way there is as close to a 1 to 1 relationship with the stock as possible as well as the least amount of premium to overcome. For instance, the December 280 call for Apple costs $24. In order for this option to make money, Apple will need to be higher than $304 ($280 + 24). This $4 represents the time premium ($304 - $300) as well as the inherent volatility in Apple that on a given day, it can go up or down anywhere from $3-7 a share on average. Take a look what happens with higher strikes. The $290 strike costs $16.50, for a $6.50 premium and the "at the money" strike of $300, trades at $10.50, representing all time premium. So as you can see, the deeper in the money you go, although you pay more for the option, you have less of a hurdle to cross to make money.

Speculation. Options are great for speculating that portion of your portfolio that is discretionary. They are cheap, leverage results and have inherent volatility which can yiled phenomenal returns that you can't get by just owning stock. For instance, take Qualcomm, on November 16, the stock traded at $46.50 a share. The December 50 cost .21 cents. So yo could have purchased 200 shares of Qualcomm for a little more than $9,000 or maybe reasonably spent $500 and bought 25 Dec 50 calls. Today, Qualcomm went up $1.6 or 3%, the December 50 calls however, increased 115%. Why? because the December 50 strike now seems a lot more reasonable with Qualcomm at $48 a share than when it was at $46.50. So even though the call is out of the money, the gains to be made as the underlying approaches the money is outstanding.

A healthy portfolio contains the right blend of risk to reward. This isn't to say that there isn't some risk with options, but if used correctly and if you're diligent in cutting your losses, the gains can far outweigh the risk and you can capture profits regardless of which direction the market is moving.

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