What are the options?

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by Bob Rinear, The International Forecaster:

There are all sorts of options plays you can have fun with. I suggest that 90% of the people should stay with the absolute basics of trading options, and that simply means buying call options if you think a stock is going to rise. It means buying a put option if you think the stock is going to fall.

Last week we closed out some call option positions that rewarded us quite smartly. We had options on the SPY which is the proxy for the S&P 500, and we bought them in the 10’s and sold them in the 30’s. We had calls on the DIA’s, which is the Proxy ETF for the DOW 30, and we were in them in the 5’s and out at the 17 level. They were very nice gains, and it evidently encouraged a lot of our readers to ask about options. What are they, how do they work? etc. So, I’m going to do a little refresher here about options, and why we like to use them at times.

First off, if someone has scared you off of options, calling them “too risky”, just ignore them. The only real difference between buying a stock and buying an option, is that options come with a time limit. Your “bet” has to work out for you in a certain period of time, or you “could” indeed lose what ever money you paid for them. But frankly you have to do some very silly things to ever lose all your “bet” money.

If you buy a stock at say 50.00 and it starts falling on you, at some point you’ll probably institute a “stop” and sell out. Let’s say you held it from 50.00 to 45 and you’ve had enough of the pain. So you sell it. Yes you took a loss, but not “all” your bet money. Same thing with options. If you buy a call option on a stock at say 10.00 and a month from now it’s down to 8.60 because the stock you have the option against is falling… you can sell that option at 8.60. Did you lose some money? Yes you did. Did you lose it all? Of course not. It’s called risk management.

So, options aren’t these horrifying things at all. They’re simply another trading vehicle, and if done right, nothing, and I mean nothing can compare. Consider the First “Vegas play” which turned 30,000 dollars into 1.2 million. That was done with options. Then the second Vegas play which we did not long ago. We showed our members what we were going to do, and we did it. We took 19 thousand dollars, and turned it into 240,000 dollars. In 7 months. Only options allow that to happen.

Okay, so what the heck are they? In simple language? They’re just another trading vehicle, just like a stock is. You buy it, you hope your right and the stock it’s attached to goes up, and if it does, you sell your option for a profit. Boom, Simple. Easy-peasy.

Here’s the deal in a nutshell. You like the XYZ company chart. You think this thing is going to rocket from 100 per share to 145 per share in just a matter of a few months. You look and see that XYZ has options available. You think the stock is going to run for about 3 months. So you go out 4 months on the options list and you buy the XYZ 100 dollar “call” options. Then you sit and wait.

Suppose you’re right and XYZ goes to 145.00. If you owned the stock, you just had a wonderful return of 45%. Hurray! So why not just own the stock? Why bother with the options? Because the options you bought at say 7 dollars per “share” are now worth at least 45. Bought at 7, sold at 45 is 542%. THAT is why we play with options now and then.

But the returns aren’t the “only” reason. Look at the amount of money you played with. To buy 100 shares of XYZ “the stock”, you needed $10,000 dollars. But to buy 100 ‘shares” of the XYZ options, you only needed 700 bucks. So, a lower cost of entry, with the “ability” for outsized gains.

Let me break it down with a real trade. Back in September we said to our members, “if this market wants to run into year end, we want to be “in” it. So we looked at the S&P proxy, the SPY. At the time, the SPY was trading at about 248 dollars. We bought the January 2018, 245 dollar call options.

Okay, so what’s that mean? It meant that from that day in September, until January 19, 2018 we had the “right” but not the obligation, to buy the physical SPY stock, for 245 bucks. As the months wore on, the S&P ( and thus) the SPY continued higher and higher. Then last week, the SPY was ending the week at 277 dollars.

Remember, we have the legal right to actually buy the SPY for 245. Well if I can buy the stock itself for 245 while it’s trading at 277, I could “exercise” my option, buy the stock at 245 and instantly sell it at 277 giving me a 32 dollar profit. But there’s no reason to do that. Why? Because the option that we bought for 10.91 was now trading at 32.65. We simply sold the option. That’s a 200% gain.

So, what would have happened instead, if the SPY had started falling after we bought our options? Then our options “value” would have started falling. If the SPY kept falling, at some point we’d have to pull the plug and stop ourselves out. Let’s say that we bought those January 245 calls at 10.91 in September, and by mid October, the SPY wasn’t up, but was down to 240 per share. Our options, bought at 10.91 might only be worth 8 bucks. We could sell them at 8 and take the loss. Or we could hold them and “hope” it’s coming back. Say it doesn’t and drops to 238 per share? Now our options might only be worth 6 bucks. We could sell it there.

Do options always reward you? Heck no, no more than stocks do. Remember, it’s not the option that is a reflection of the underlying company, it’s the stock. You buy the stock of IBM if you think IBM the company is going higher. You buy a “call option” against the stock of IBM if you think the company is going higher. As you know, sometimes they don’t follow the plot and stocks do go down. If you bought the stock, and the company misses earnings, your stock will get hit. If you have the options on IBM stock and the company misses earnings your options will get hit. Same thing.

There are all sorts of options plays you can have fun with. I suggest that 90% of the people should stay with the absolute basics of trading options, and that simply means buying call options if you think a stock is going to rise. It means buying a put option if you think the stock is going to fall.

With stocks, if you want to make a profit as the market is falling, you either have to buy an “inverse” ETF or you “short” the stock. With options you buy a put. Put options increase as the price of the stock falls.

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