Smart Saving and Investing

In What is an Option? - Part 1, I covered the two types of options - a put and a call.

Here are some option attributes:

• options are like ice cubes, they are worth something and then melt away to nothing ($0.00) over time.
• one option typically represents 100 shares of stock.
• there is an expiration date that is set - think of this as the day the option is all done melting away to $0.00.
• there is also a strike price or set price - this is the price of the stock that is set no matter what the stock is worth on the expiration date.
• expiration day is always the third Friday of every month. That is when your option is worth $0.00. Typically at the end of the trading day on the third Friday of the month that your option expires.
• a call option allows you to buy the 100 shares of stock at a fixed priced on or before a fixed day, expiration day.

But here’s the kicker - we don’t want to buy the stock. As options traders we want the stock to go up so our call option goes up as well. If there is enough time left before our call option expires and the stock value goes up, most likely the value of our our call option will go up.

In reality, a call option allows us to buy the 100 shares of stock for a fixed price no matter what the market price is for the stock. If we bought a $10.00 call option on an $8.00 a share stock and it went up to $12.00 a share, we certainly could buy the 100 shares of stock for $10.00 a share rather than $12.00 a share because we paid for the right to do that when we bought our call option. WOW!! I know that’s a lot to take in but read it over and over until you get it. If you have any questions post them in the comments area.

However, if that stock went up to $12.00 a share, that means our call option would go up as well. As long as we haven’t reached the expiration date, our call option should be worth more than what we paid for it. Remember, it costs us a lot less to buy a call option than 100 shares of stock.

The Down Side

Yes, there’s a down side. If the value of the stock stays the same or goes down and stays that way up to the end of expiration day, then we’ll lose money. For example, if we buy a call option on a stock that is worth $8.00 a share and we hope it goes to $10.00 a share or more but it never does, then our option will go down and down with every passing day until expiration. Remember that melting ice cube?

Another Example

Like the POZN call option we talked about last week and profited handsomely (on paper anyway) on, we’ll take a look at another one this week. The stock is Taiwan Semiconductor, symbol TSM. The October 10 calls are being bought up like something crazy!!

Look at the options table below taken from Big Charts:

That is what we call institutional buyers coming in and hoping to snag a deal because they know something we don’t or they’re just desperate to make some money at the end of the summer. We call these guys the “smart money”. Well, let’s hope that’s all true.

Again for this example, we could buy 1 call option contract for $50.00 (.50 times 100 shares of stock) or we could really gamble and buy 10 contracts for $500.00 (.50 times 1,000) or if we’re feeling really giddy we could buy 100 contracts for $5,000.00 (.50 times 10,000 shares of stock) . That sounds good to me.

We’ll paper trade this, which again means we’ll write it down on paper (or this blog) that we paid $5,000.00 for 100 contracts of the September 10 Calls, option symbol TSMJB.

On another note, if you want to do this trade over at the CBOE, you can use their Virtual Trade Tool to see what happens. Maybe I’ll do a post on their Virtual Trade Tool sometime. But if you feel you understand some of this go over and read about the Virtual Trade Tool and give it a try. If not, stop back soon to see what happens with this trade.

If we get a nice move up between now and the third Friday in October 2007 we’ll make a good chunk of change and be done with it.

We’ll also be looking to exit this position if we lose too much as well. We won’t set a limit of what we want to make just yet since we have over a month to watch this trade. We also won’t set a limit on the downside just yet because of the time that we have and the fact that stocks and their options can jump all over the place in a short period of time.

If you have any question about options let me know and always remember, “Pigs get fat, hogs get slaughtered!!”

written by Bill Stevens

This is an update on where we’re at with our POZN September 10 Call Option position that I talked about last Friday, 8/17/07.

As I write this post, 9:35am on Wednesday, 8/22/07, the POZN September 10 Calls are selling for $1.00. If you remember from our post last Friday - What is an Option? - Part1, the POZN September 10 Call Option was selling for .45 cents.

We decided to paper trade (fictitious trading on paper) one contract (one contract represents 100 shares of a stock) of the POZN Septemeber 10 Call Option. So we have to take the .45 times 100 and we would have paid $45.00 for the contract. Hopefully that makes sense to you.

I also said we’d close our position after we profit with a 25% gain on our money. So at $45.00 for our one contract it would have to go to 56.25 to make our 25% profit on our money. 25% of 45 is 11.25. So add the 11.25 to 45.00 and that gives us $56.25. The value of our option that we would sell to make 25% on our money.

If we were really trading this position, we would have immediately put in a sell to close position at .56 in our options brokerage account. In other words, we determine how much we want to make on our trade and right after we open a position we set where we want to sell it.

Remember that saying, “pigs get fat, hogs get slaughtered.” This is the point where a lot of folks could lose money, because they don’t set their target price of when to get out of their position (sell). We’ll talk more about that in another post.

The market opened this morning with a bang, up, up, up.

Graphically, here’s where we’re at.

Last Friday’s numbers on POZN:

After the big opening this morning here are the POZN numbers below:

So we purchased the POZN September 10 Call Option for 45.00 and we could sell it right now for 1.00 but we can’t because we set our automatic exit point to 56.25 which would have triggered automatically and sold our position.

That’s huge gains folks and we could have sold it now for a bigger gain or possibly lose it all, if it goes down between now and the third Friday of September when options expiration happens and our call becomes worthless.

So for fun, if we would have sold for $1.00 as the chart indicates its value, that would have been approximately a 110% gain on our money. That’s why options are so much fun and dangerous. I’ll talk about the dangerous part in another post.

Let’s Play!!

Again, let’s play with some bigger numbers. Let’s say instead of one contract we would have bought 10 contracts for $450.00. Ten contracts equate to 100 times 10 which equals 1,000 shares that we control.

If we sold our 10 contracts at $1.00 that would have been $1,000.00 for a gain of $550.00. $1,000.00 minus $450.00.

Not bad for a few days of work for our money. The trick is to do this a few times a year and it will fund your Roth IRA automagically.

Ok, let’s start dreaming, say you bought 100 contracts at $4,500.00 and you sold at $10,000.00. That’s $5,500.00 profit in a few days. Yikes!! Vacation time folks.

Of course I’ve left out the brokerage fees for opening and closing the position but still, we’re “in-the-money“.

written by Bill Stevens

An option is a contract that provides you with the right to buy or sell 100 shares of a stock.

Typically, one option contract represents 100 shares of stock. An option gives you the right to buy or sell 100 shares of a specific stock for a set price on a set date. You can do this without owning the stock.

However, think of an option as an ice cube. With every passing day the option becomes worthless. The option is a decaying asset that ultimately ends up being worth nothing - $0.00.

There are two kinds of options, a call option and a put option. One call option indicates you want to buy 100 shares of stock and one put option indicates you want to sell 100 shares of stock.

Let’s say you want to buy one option contract on the stock Pozen Inc, symbol POZN. Pozen is a pharmaceutical company that focuses on various pain-related conditions such as acute and chronic pain.

First we determine if we are buying the option contract because we’re bullish on the stock, in other words we think it will go up, or we’re bearish on the stock, we think it will go down. In this example, we’ll be buying a call option which means we’re bullish on the stock and we think it will go up.

We think POZN is going to go up because we’ve been following the “smart money” and it looks like there’s a lot of interest in the September 10, 2007 call options. When I say “smart money” I am talking about the institutional investors. Those are the investment teams who have huge amounts of money to move markets. The Fidelity, Vanguard, and T. Rowe Price types. Notice the volume below in the red square. So we’re looking at the call option listed at BigCharts that is labeled QKZIB.

The price of the stock closed at $8.79 a share as indicated in the “Strike Price” column that is dark purplish. The strike price we think the stock will go to or past is $10.00 a share. Using our opening definition above of an option has a set price, the strike price then is our set price. We are betting our stock POZN will make it to $10.00 or more a share by the third Friday in September 2007.

The third Friday of every month is Options Expiration day. That is when your option expires or is no longer valid. At the end of the day for most options. That is the part of our opening definition explained above, an option has a set date and it’s the third Friday of every month.

So hang with me here. If we buy one contract for 45 cents (see the column to the far left of the red square below labeled “Last”), we are actually taking 100 shares times 45 cents. That comes to $45.00 to buy this one contract of POZN to control 100 shares of stock - 100 x .45 = $45.00.

Now, imagine buying 100 shares of POZN for $8.79 a share - 100 x 8.79 = $879.00. So you can immediately see that to buy the 100 shares at $8.79 a share would cost us $879.00 and the call option would only cost us $45.00 to “control” 100 shares of POZN.

At this point, let’s clear our minds and empty our brains. Here’s what we’re thinking at this point:

We want to buy the September, 2007 call option on the stock POZN that has a strike price of $10.00. We think the stock will go up to $10.00 a share or more. We are going to pay someone who owns those 100 shares of POZN $45.00 to reserve that price for us. That way if the stock goes above $10.00 a share (our strike price) we’ll be able to buy 100 shares of the stock for $10.00 a share.

So the “somebody” who sells us the call option is really selling us what’s called a covered call to the seller. We’ll discuss covered calls in another post.

Again, for that right that we get to purchase POZN at $10.00 a share, we’re paying someone $45.00.

What we’re really doing here is hoping the stock goes up because the value of the call will (should) also go up. That is all we’re interested in, really. If we make a profit on our call option, then we’ll bail (sell it).

So we stay true to ourselves and not get lured in by what could come of this option, we need to set a target of what we want to make before we close this position. For this example we’ll say, if we make 25% on our money, we’ll close the position by selling it. Remember, “pigs get fat, hogs get slaughtered.”

This is an aggressive play because we only have one month until the third Friday of September 2007. As the trading days go by, our melting ice cube of an option will lose value. That value is calculated based on a rather complex mathematical formula that goes beyond this post.

Now, I haven’t even talked about things like technical analysis or fundamental analysis. When we’re playing options, usually we don’t care about the underlying company. We’re just hoping the stock moves in a big way up or down. In this example, we want POZN to move up, up, up.

So that’s what we’ll do for the next few days is hope that our stock moves up. With the volatility in the markets lately we should find out pretty quick. We’ll do what’s called paper trading, which means we really won’t place this trade. We’ll just write it down on paper and watch.

Cross your fingers and get the bubbly ready.

written by Bill Stevens

Hopefully this will become a weekly post about “Funny Money”. What is “Funny Money”? I’ll start by referencing John C. Bogle’s (Founder and former CEO of the Vanguard Mutual Fund Group) fantastic book, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Book Big Profits).

On page 202, Chapter Eighteen, “What Should I Do Now: Funny Money, Serious Money, and Investment Money“, Mr. Bogle talks about “…trying out modern remedies for age-old problems lets you exercise your animal spirits. If you crave excitement, I would encourage you to do exactly that. Life is short. If you want to enjoy the fun, enjoy! But not with one penny more than 5 percent of your investment assets.

So my “Funny Money” or drug of choice if you will, are Options. Stock Options. Options can be dangerous. I do not recommend them to the faint of heart. You can lose a lot of money quickly with no come back in sight.

Options are a depreciating asset over time. I’ll reserve the many definitions for another time or times. Unlike a stock where you can hold a stock forever (most of the time) to see if it recovers from losses, options have a defined length of time to make you money or make you lose money.

I will reserve for another post how I lost a bunch ($$,$$$.$$) in Options when I first started trading them. Ouch!! It pains me to remember it all.

But now, I’ve gotten a bit wiser and more patient when it comes to trading Options. For this example I’ll talk about a recent options trade I made in the last two weeks.

On Tuesday, July 10, 2007, I purchased the AU August 45 Calls (AUHI) for .85 cents. I purchased 10 contracts which allows you to control 1,000 shares of AU stock. I know that sounds confusing but like I said, I’ll write about the definitions of Options in another post.

One contract allows you to control 100 shares of AU which means you take 100 shares x .85 cents and you get $85.00 for one contract of AUHI, the AU August 2007 45 Calls. Thus, 10 contracts = 1,000 shares x .85 cents = $850.00. Got that?

The month of August tells us that this “deal” is no longer valid after the third Friday of August when it expires. Why the third Friday of August? Because, Options expiration always lands on the third Friday of every month.

So with this trade, I was believing that between Tuesday, July 10, 2007 and Friday, August 17, 2007, the AU August 45 Calls (AUHI) for .85 cents would appreciate enough to make me some moola. Well, they did appreciate because the stock rose in value which makes Call Options rise in value, typically.

Why and how did I know to do this trade? Well, I listen to Jon and Pete Najarian for FREE (everyone can) at The Chicago Board Options Exchange where you can watch them (usually Jon) at least twice a day. They give up some valuable information for Options traders.

This particular Option play showed Jon and Pete that there was huge trading on the AU August 45 Calls (AUHI) and they kindly relayed it to their listening public. You can see this at many stock chart sites that display options and I use Big Charts where you can search on the symbol AU and then select the “options chain” link that would show you the AU August 45 Calls (AUHI) were trading in huge volumes compared to other AU Options. See the screen shot below.

See the 11,361.00 in “Open Interest”, another term we’ll talk about later. That is huge, abnormal volume compared to the other levels for the stock AU and that means it was most likely big time institutional investors taking advantage of this Options play. Somebody knew something was going to happen or folks were just plain bullish on this stock.

The stock symbol AU stands for AngloGold Ashanti Limited, and they are an exploration and mining company. Today, 7/19/07 I sold my 10 contracts for $1.50 each. So back to our bit of math from above. 10 contracts = 1,000 shares x 1.50 = $1,500.00. That’s what they sold for minus commissions of approx. $40.00 or approx $20.00 on each side of the trade, $20.00 to open the trade and $20.00 to close the trade.

So I made $1,500.00 minus $850.00 = $650.00 minus $40.00 approximately for fees. So a nice $610.00 profit in 8 trading days. Who knows, I could have waited for more gains because they don’t expire until the third Friday in August, 2007. But there is a saying that you must memorize when trading Options, “pigs get fat, and hogs get slaughtered!!” This means, you have to know when to get out and be happy with what you’ve made.

So the final question is, what percentage did I make on my money? $610.00 / $850.00 x 100 = 72% return on my money. Holy Kamolie!! Cha-Ching!! Wouldn’t that be great to do every day? Yea, right!!

Again, there’s my funny money and “excitement”. But, it could have gone the other way too. Which would have been bad and I would have been forced with some heavy decisions before the third Friday in August 2007.

Hopefully this wasn’t too much to digest and like I said previously, I’ll define some Options terms in another post or two. Have a great weekend!!

written by Bill Stevens

So if you followed my entry on the July 12.50 MNKD Calls the other day, they closed yesterday at $2.35. So apply the math, you got in at .75 cents and bought 100 contracts for $7,500.00 last Thursday, 6/7/07.

Remember, you have to buy at least one contract and one contract is worth 100 shares of stock. So one contract is .75 cents times 100 shares of stock for $75.00. Take that times 100 contracts and you get the $7,500.00 I was talking about.

Let’s say you closed (sold) your position yesterday for $2.35 times 100 for a grand total of $23,500.00 minus trading fees and taxes you’ll have to pay next year on the money you made, $23,500.00 minus $7,500 = $16,000.00 profit. SMACK!! Jeepers Wally!! That’s enough to fund both my Roth IRA and my wife’s Roth IRA.

That’s the power of options and it’s also the danger of options. If the trade went the other way you could have lost thousands of dollars.

Have a great day!!

written by Bill Stevens