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NOVICE TRADER
Basic Options Techniques
by Mark Vakkur, M.D.
Many stock traders and investors avoid options because they seem too complex or risky. Although it is very easy to lose large amounts of money in a very short time misusing options, investors and traders of all kinds should at least consider them as one of many tools to exploit market opportunities. Here's a primer on using options, with common terms and applications of options strategies.
Although a thorough discussion of options is impossible in the space of a single article, it is important to introduce a few basics. There are, if nothing else, two outstanding but little-used options strategies for the markets that should be discussed -- buying deep-in-the-money call options as a proxy for purchasing the stock and selling options against that position to create a high-probability, high-return alternative to conventional covered-call writing. The paradox of these strategies is that despite their reputation as being risky, they can be less risky than buying the underlying while offering all, if not more, of the potential return.
OPTIONS AROUND US
We all own options, whether we realize it or not. Car insurance is nothing more than a put option on our car; for a small, guaranteed loss (the premium), we purchase a contract (policy) that will expire worthless unless our car decreases in value before the expiration (the life of the policy). In this case, we are the option purchaser and the insurance company is the option seller.The analogies continue. We are exchanging a large, possibly catastrophic risk (the theft of the car, say) for a much smaller risk (the loss of the money spent on premiums). The option seller assumes this risk only because the probability of the catastrophic loss is relatively small (you might collect money in one year out of 10, and often for far less than the value of your car) and spread among a large risk pool (all the other policyholders). If the option price (premium) reflects reality, over time the insurance company's core business will make money. (Remember that Warren Buffett made more money for Berkshire Hathaway shareholders through his insurance company than through the investments that made him famous.)
So how is this option price determined? Again, using your car as an example, the magnitude of the loss must be determined if your car is totaled. Say this is $30,000. If there is a 10% probability of this occurring in a given year, then an annual policy should cost at least $3,000 (10% of $30,000). This is the expected loss. If you issued an infinite number of policies charging $3,000 for each one, you would expect to break even, since your expected loss equals your premium gain (from the insurance company's point of view). An insurance company needs to do more than break even, so you will always pay more than the expected loss (if calculated correctly) in premiums. In this case, a policy might cost $3,500 a year or more.
Clearly, the two most important determinants of option price are the potential loss (or gain) and the probability of this event occurring. An 18-year-old male has a much higher than 10% probability of getting into an accident and so will be charged more than a 45-year-old woman for an insurance policy.
Excerpted from an article originally published in the August 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.