Know your options: want a flexible way to make your money grow? Consider options - Personal Finance

Entrepreneur, Sept, 1996 by Lorayne Fiorillo

PUTS, CALLS, spreads, straddles--no, it's not the latest exercise plan; it's part of the language of options.

At first glance, learning to use options successfully can seem impossible. But it can be worth the effort because options do what few other classes of securities can: They allow investors the flexibility to make the most of almost any investment opportunity. In short, options give you options.

Instead of limiting your participation in the stock market to buying or selling, options let you tailor your activity to your perception of what may happen next. You can protect a profitable position from future market declines, buy a stock at a price lower than its current market price, increase your income from current stock holdings, or position your portfolio for a big market move (even if you're not sure which way it may be going).

It's hard to know too much about options--and this is one case where only a little knowledge can be dangerous to your financial health. To whet your appetite, here's a taste of how options work and some ideas on how

* WAIT WATCHERS

Burger lovers, who could forget Wimpy, who would gladly pay you Tuesday for a hamburger today? Options work on the same principle, providing an opportunity to invest tomorrow for a small down payment today. Although they've been around for centuries, it was not until 1973 that standardized, exchange-listed, government-regulated options became available. Options can be traded on stocks, commodities or futures. For the sake of simplicity, let's concentrate on stock options.

Stock options are contracts that allow investors the right, but not the obligation, to buy or sell a particular amount of the underlying stock for a specific price during a particular period. Most options are based on 100 shares of an underlying stock. Not all stocks have options available, but more than 1,600 stocks do. Here are some basic options terms:

* The strike (or exercise) price is the price at which the shares of stock will be bought or sold to the holder of the option (the buyer), should he or she choose to exercise the option. Strike prices are listed in increments of 2.5, 5 or 10 points, depending on the price of the underlying stock.

* The premium is the price paid by the buyer of the option for the right to buy or sell shares of the underlying stock. It is also the amount received by the seller of the option for allowing shares to be taken away. Option prices rise and fall with the price of the underlying stock. Unlike stock investors, the holder of an option is not entitled to dividends.

Some stockholders wait years for their stock to go up. Option holders don't have that luxury. Unlike stocks, options have a limited life: All options have an expiration date, usually in three to nine months, so option holders must make hay while the sunshines.

If, as the holder of an option, you haven't made money on your decision by the time the option expires, it becomes worthless. The longer the time available before expiration, the more valuable the option. This time value decreases as the option gets closer to itS expiration date.

* HAVE YOUR STOCK AND SELL IT, TOO

There are two types of options--puts and calls. Call options give their holder the right to buy a particular stock at a particular price; put options allow holders to sell stock at a particular price.

The buyer (or holder) of a Dec 50 call on ABC stock can buy 100 shares of ABC, at $50 per share, at any point from the time the option is purchased until it expires in December. If the price of ABC goes to, say, $100 per share before the December expiration date, the call holder can exercise the right to buy at $50.

Call holders can also close their option position by selling their option. In this case, because of the increase in the price of the underlying stock, the call holder could sell the option and reap a profit.

If the price of the stock dropped dramatically, you simply wouldn't exercise your option to buy. Thus, the maximum loss a call buyer could experience is the cost of the call. Call buying is considered a bullish strategy: Investors who think the price of a stock will rise buy calls.

Put options allow holders to sell a stock at a specific price. A put buyer (or holder) of a Dec 50 put on XYZ stock can sell the shares of XYZ at the strike price ($50, in this example) no matter how low the price may go. Investors who feel that the price of their stock may fall, but who don't want to sell at the moment, can buy a protective put. This strategy is called a married put, and it limits an investor's potential loss to the cost of the put plus the difference between the purchase price and the strike price.

If the stock price falls below the exercise (strike) price, the value of the put will rise. The option can be exercised or sold for a profit. If the price of the shares does not fall before the option expires, it will expire worthless. Buying puts, then, allows investors to protect themselves from the downward movement of stocks and is considered a bearish strategy.