CHAPTER 1
A FEW BASICS
One of the greatest pieces of economic wisdom is to know what you do
not know.
—John Kenneth Galbraith, in Time Magazine, March 3, 1961
I
magine investing in a company, holding shares of stock
for the long term while earning a nice dividend each year,
and watching your portfolio grow over time in a robust
and healthy economy. Now imagine expanding this idea to
create additional benefits. These include being able to take
profits when they occur as a result of short-term overreac-
tion in the market, to protect your stock against price de-
clines, and to use your shares of stock to increase current
income each and every year—when the stock rises and
when it falls.
That environment does exist. With the careful, well-
planned use of options, you can manage your portfolio to
reduce overall risk while increasing current income. At the
same time, you can satisfy the urge to speculate without
placing your long-term investments at risk. You might not
think of yourself as a risk taker, but most people like to
imagine what it would be like to play short-term price
5
6 Winning with Options
movement and make a little extra money doing so. If you
are typical, you probably have not gone down that road
because you do not want to place your investment capital
at risk, and that is a legitimate reason to play it safe. How-
ever, this book lays out a series of strategies involving
options that you can use to create the ideal stock environ-
ment without added risk. Options are flexible and present
many great opportunities, making them a practical income
generator and risk-reducing device.
Ground Rules for Stock Selection
You have probably heard about options in terms of high
risk and high loss. They are often seen as speculative ‘side
bets’ that only the high rolling risk taker wants to use. But
this is not necessarily the case. A large number of option
strategies are actually low-risk and worth considering even
in the most conservative portfolio.
To establish a clear definition of options and how they
work, you need to be aware that an option is merely a
‘right.’ It has no tangible value and only grants its owner
the ability to transact stock at a predetermined price. This
gets interesting when the stock price moves above or below
that set price. The more the movement of the price, the
more valuable the option becomes—because the option
fixes the price of the stock, no matter what its market price
is at the time.
To understand this in a way familiar to many people,
consider the case of a real estate lease-option contract.
Under this deal, a person who wants to buy a home enters
into a lease with the owner, agreeing to pay a specified
amount of rent for a period of years. In addition, the con-
tract specifies that at any time before expiration of the
lease, the tenant also has the right (the ‘option’’) to buy
7AFewBasics
the house at a specified, fixed amount. Therefore, even if
the market value of the home doubles, the tenant has the
contractual right to exercise the option and buy the house.
Numerous possible outcomes can occur, as shown in the
example below.
EXAMPLE
You want to buy a house currently valued at $265,000 but
you do not have the down payment. You believe that you
can save up enough to buy the house within three years,
so you offer the owner a lease-option. It specifies that you
will make lease payments over a 36-month period, and
also that at any time you can exercise an option to buy the
house for $265,000. At the end of the lease term, the op-
tion expires. Several outcomes may occur:
You are unable to save enough, or the house actually
declines in market value. You allow the lease to expire
without taking any action.
The house doubles in value to more than $500,000 and
you exercise the option. The owner is required by con-
tract to sell the house to you for $265,000.
The property increases in value and the owner does not
want to sell, so he offers to buy your option from you.
The price is negotiated based on current market value
versus the option value of the property.
Thekindofrealestatetransactionshowninthisexam-
ple occurs quite often. Now apply the same concept to the
stock market and you have a fairly good idea of how it all
works. For the price you pay to buy an option, you fix the
price of stock. A call option gives you the right (but not the
obligation) to buy 100 shares of a specific stock, on or be-

Get Winning with Options: The Smart Way to Manage Portfolio Risk and Maximize Profit now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.