Basic Options Trading:

Options Strategies For

Beginners

By Seeking Alpha Contributor Rocco Pendola

Introduction

Section 1: Basic Options Definitions and Concepts

Section 2: Options As Investments

Section 3: Writing Covered Calls

Section 4: Long Calls And Puts

Section 5: Cash-Secured Puts

Acknowledgements, Resources and Disclaimers

Introduction Throughout 2011, I wrote hundreds of articles for the popular stock market and investing

website, Seeking Alpha. A considerable portion of my writing focused directly on options

trading and investing. In a majority of the articles where I discussed or suggested specific

trades, I employed options as the vehicle to execute the trades.

In August, I began writing a series of articles that followed my goal to double the value of a

simulated $10,000 trading account. In just over a month, I managed to achieve the double. By

the middle of December, the account had more than tripled to over $32,000. With one

exception, every trade used options.

I fully understand the difference between trading real and “simulated” holdings. Who knows if I

could have produced the same results while experiencing the emotions that go along with

putting actual capital on the line? While I am proud of the portfolio’s performance, it was about

more than bragging rights. I used the $10,000 portfolio series and many of my other articles, at

least in part, to show readers that they can use options to reflect all types of sentiment with

less risk than buying or shorting stock.

The feedback I received to my options-related work split into two distinct themes.

First, some readers resisted my reliance on options, often calling it too risky or not for small

investors. I disagree. Options, particularly early-stage options strategies, present less risk and

more opportunity for investors of all types who take the time to learn a few basic rules and

follow several simple tenets.

That said, investors who are skeptical about options probably should be. With options, you can

keep yourself out of trouble, if you make things simple. Avoid taking in more information about

how options behave than you need. If you stick with introductory strategies – and use them

only within a few contexts – you likely do not require this information for success. It often only

triggers confusion.

Most investors, namely relatively small ones, should never venture beyond the most basic

options strategies. When you move away from the basics, particularly if you become

overconfident after experiencing early success, you stand a better chance of seeing your initial

fears realized and hesitation justified than if you just stuck to playing it safe.

The four options strategies I focus on –covered calls, long calls, long puts and cash-secured puts

– should not serve as gateway drugs to more advanced and complicated options strategies.

I employ the same logic when I argue that small investors should stay away from margin (or use

it sparingly and with caution) as I do when I advocate against going past long calls, long puts,

covered calls and, in limited instances, cash-secured put writing.

Imagine you are a small investor who opens a stock trading account. Depending on your

personality, you might have a difficult time resisting the urge to trade on margin. Once you get

to the level to receive margin approval, it can be tough to ignore the allure of the extra buying

power that comes along with trading “the house’s money.” If you’ve experienced success

buying and selling stocks, it’s natural to want to use leverage. If you have not experienced

success buying and selling stocks, it’s natural to want to use leverage! Simply put, many humans

have an aversion to the notion of doing more with less, while failing to acknowledge the

potential pitfalls of trying to do more with more.

The second you get that first margin call, the fear it strikes in your heart renders the idea of

trading on margin too rich for your blood. Something similar happens to the investor who, all of

a sudden, finds herself in an option situation she does not understand. This person can get

stung by more than just the margin-related problems these situations often bring. The investor

simply entered into a position that, even if she made the right directional bet, has too many

variables impacting its likelihood of success. Forget about intermediate to advanced strategies;

traders and investors can get burnt using long calls, long puts, cash-secured puts and, to a

lesser extent, covered calls if they are not careful.

While it’s natural to want to move on to something more advanced after you have developed a

sound grasp of the basics, you are probably better off knowing when to say when in investing,

particularly when dealing with margin or trading options. Just as you likely make the prudent

move taking money off of the table on a winning stock trade, you can save yourself quite a bit

of time, heartache and, most of all, money by learning the most basic options strategies and

using them within the confines of an ultra-disciplined and relatively conservative approach.

The other theme that emerged from my Seeking Alpha work on options caught me by surprise.

On an almost daily basis, to this day, I receive personal communication and public comments to

my articles from readers seeking basic options information. These individuals want to know

where to go to learn the first few things about options. Some make the query from scratch,

asking for the definition of a call and a put or the meaning of ITM (in-the-money), ATM (at-the-

money) and OTM (out-of-the-money). Others know the jargon, but wonder why their

Priceline.com (PCLN) calls tanked the day after earnings even though the company blew away

its estimates and the stock soared.

By and large, the readers I interact with want to start using options, but, rightly so, they do not

want to jump in before they are better prepared to properly act and react.

Clearly, these conversations provide the inspiration for this eBook.

I divide this eBook into five sections.

In the first, I cover the most basic definitions and options concepts. I only go as far as necessary

to ensure that you (A) understand what follows and (B) can take the next step to implementing

options strategies into your investing. I do my best to not include information that only serves

to confuse new options investors. If you cannot apply it to a basic and relatively conservative

options trading and investing game plan, I do not bring it up.

In the second section, I explain why I refer to options as investing. When most people think of

options, they think of trading. To some extent this makes sense. You can classify most investing

transactions as trades. When you buy a stock, you open a trade. When you sell, even if you wait

65 years before doing so, you close a trade. If you never close it, passing on a stock position

from generation to generation, you still have an open trade.

All isolated options trades must end at some point, whereas a stock trade could, theoretically,

go on forever. The almost-automatic connotation, however, between options and trading

misleads investors, adding to the false notion that options pose more risk than stocks. When

used properly and in limited fashion, they do not. You can be an options investor. You do not

have to be a trader in the speculative, risky (or risqué) sense of the word.

In the third, fourth and fifth sections, I cover covered calls, long calls/long puts and cash-

secured put writing.

Section 1: Basic Options Definitions and Concepts Because I aim to present information in the clearest, most straightforward manner possible, I

will break from my normal style of writing and general writing convention often. I want you to

be able to use this book as a logically-flowing roadmap to understanding the very basics about

options and turning that knowledge into a workable and relatively safe options strategy. Think

of this as more of a workbook or a progression of concepts, thoughts and ideas, rather than a

traditional text. If fragments, bullets and dashes work better than complete sentences to

convey key points, I will use them.

I have thought long and hard about the best order to present this information so that each

point introduces a new point to define, but in easy-to-follow fashion. I hope it makes as much

sense to you as it does to me.

Key starting points

*Each option contract (a call or a put) represents the right to buy or sell 100 shares of the stock

that underlies the option.

*Like a stock, each option contract trades for a market price, known as a premium. Premiums

use a multiplier of 100. For example, if the market prices an option at $2.00, it will cost you

$200 to buy one contract.

*Conversely, you would receive $200 for selling an option contract that trades for $2.00. Of

course, you receive the premium less commission charges.

-A $10.00 option = a $1,000 debit or credit, excluding commission.

-A $25.00 option = a $2,500 debit or credit, excluding commission.

-A $100.00 option = a $10,000 debit or credit, excluding commission.

*Like stocks, options use a bid and ask price. You sell for the bid and buy at the ask. If you sell

an option, you receive the bid price. If you buy an option, you pay the ask price.

*As with stocks, you can place limit orders when buying and selling options contracts. You

should always use limit orders to buy and sell options, particularly on thinly-traded contracts

with wide bid/ask spreads.

*When you are long an option contract, you have the right, but not an obligation (hence,

option) to exercise your option to buy (in the case of a call) or sell (in the case of a put) 100

shares of the option’s underlying stock for each contract you own at the contract’s strike price

on or before its expiration date.

AAPL January 2013 $400 Call

AAPL (ticker symbol) January 2013 (expiration month) $400 (strike price)

Often quoted in the following or similar form: AAPL130119C00400000 where AAPL is the

ticker, January 19 2013 is the exact date of expiration and C00400000 represents a $400 strike

price call contract.

*If you decide not to exercise your option to buy or sell the underlying stock, you can sell the

contract on or before its expiration date. You receive the premium (on the bid) the market

currently has on the contract.

*In the most general sense, if the options trade went your way, you should be able to sell the

contract for a higher price than you bought it for.

*I say “in the most general sense” because myriad factors influence how an option premium

acts. You can be right about direction, but still make a losing options play. I argue that

beginners and investors who view options as short-term investments rather than swing trades

should work to minimize the number of variables likely to impact their position.

*If you do not choose to exercise a long call or put or sell the premium to close the position,

one of two things will happen:

-If your contract expires “in the money” (I define that in a second) by $0.01 or more, your

brokerage will, almost always, exercise your right to buy or sell the underlying stock for you,

unless you instruct it to do otherwise.

-If your contract expires “out of the money” (I define that in a second as well), it expires

worthless. This means that it has no value, which, along with expiration, prohibits you from

selling the contract to reap proceeds.

At this point, it’s important to define several terms to help bring what I have covered so far into

focus.

Buy to open: When you initiate a long call or put position (buy the contract and pay the

premium’s current ask price), you select “Buy to open” from your brokerage platform.

Sell to close: When you close a long call or put position (sell the contract to receive the

premium’s current bid price), you select “Sell to close” from your brokerage platform.

Sell to open: When you initiate a short option position (you sell, aka write, a call or put and

receive its bid price as a credit to your account), you select “Sell to open” from your brokerage

platform.

Buy to close: When you close a short option position, you select “Buy to close” from your

brokerage platform. Remember, when you sell an option contract, you receive a credit to your

account equal to the bid price you receive for writing the contract. If and when you choose to

close that position, ahead of expiration, you must buy it back at the current ask price.

(In each case, of course, you can – and should – use a limit order to ensure that you receive a

favorable price on the bid or ask).

When you buy to close a short option holding, your account position changes from a negative

number (for each contract you were short) to no position. For instance, if you sell to open 2

Apple (AAPL) March 2012 $350 puts, your account shows the position as something like “-2

AAPL March 2012…”

If you buy to close that position, you keep the difference between the credit you received when

you opened the position and the lower price you bought it back at, assuming the premium

moves lower. In many, but not all cases, this is what you want to see happen when you are

short an option contract. You want the premium to move lower, which, generally speaking,

indicates that you made the correct directional bet.

*Distinction on “the difference between the credit you received… and the lower price you

bought it back at…” – Nothing happens to the credit you receive when you sell an option

contract. No matter how the trade works out, you keep that credit. In fact, the moment the

trade settles (options settle on the next trading day, unlike stock trades which take three days

to settle), you can do whatever you like with that credit. You can use it to buy something else,

keep it as cash, withdraw it and buy a snack, etc. When you debit your account to buy to close a

short option position, you pay the going premium to do so. Your brokerage debits your account

for that amount. For gain/loss and recordkeeping purposes, you consider this debit up against

the original credit you received. While you’ll need funds available to buy to close a position,

that original credit does not get held back beyond the settlement date.

*Example: You sell an option (a covered call) for $2.50 and receive a $250 credit. The trade

settles the next day, therefore that $250 becomes available to withdraw. You withdraw it,

leaving your account with a zero cash balance. Five days later, your short option holding is

worth $2.00. You want to buy it back. To do so, you will need to deposit the required funds into

your account. If you do and proceed to buy to close the position, you consider your profit from

the trade $50. This hypothetical does not factor in commission charges.

*Possible exception: If you are short an option position that is not covered by stock, e.g., a

naked call or put, you might need to keep the credit received in your account to maintain the

necessary account equity for margin purposes. This depends on the composition of cash and

other positions in your account.

If the premium of an option contract you are short moves higher, you can still buy it back to

close the position, however, you will end up paying more than the original credit you received

when you sold the contract.

Generally, you sell a put to indicate bullish sentiment, meaning you think the underlying stock

will move higher or simply not drop considerably. If this happens, the premium will decrease in

value as time passes, ultimately expiring worthless assuming the stagnant or upward trajectory

in the underlying stock stays intact.

In some cases, however, you sell a put in an effort to get assigned shares of the underlying

stock. In this case, you want the stock to drop so that it triggers assignment. Assignment refers

to the party you sold the option contract to exercising his right to sell the stock (to you) at the

contract’s strike price. This is what options traders refer to when they speak of selling a put to

get long a stock.

Broadly speaking, you sell a call to indicate bearish sentiment, meaning you think the

underlying stock will move lower or simply not rise considerably. If this happens, the premium

will decrease in value as time passes, ultimately expiring worthless assuming the stagnant or

downward trajectory in the underlying stock stays intact.

In some cases, you will sell a call against a position you own in the option’s underlying stock.

This is known as a covered call because your stock position “covers” your short option position.

I will get into covered call writing in detail later, but, for now, realize that covered call writing is

one of the most basic options strategies. The aforementioned naked call writing, meaning you

do not own a position in the underlying stock to cover your short call position, is advanced. I

will not get into much detail on that strategy in this book, as it is not for beginners, nor is it a

strategy I ever employ.

This last page or so will make more sense when I discuss writing covered calls and selling cash-

secured puts.

For now, here’s the big takeaway. When you are long (you purchased) an option contract, you

own the right to buy or sell the underlying stock at the contract’s strike price on or before

expiration, but you can opt to sell the premium to somebody else on or before expiration, let it

expire worthless or watch your broker automatically exercise your right to buy or sell if your

contract sits in-the-money at expiration. When you are short (you sold or wrote) an option

contract, you give somebody else the above-mentioned choices and must deliver the stock

(when short a call) or buy the stock (when short a put) if they choose to exercise their option.

You receive money – the option premium in the form of a credit to your account – in exchange

for accepting this trade-off.

Option Approval Levels

You will not be able to buy to open, sell to close, sell to open or buy to close options in your

brokerage account until you receive permission from your broker to do so. Most brokerages

permit customers to apply for options approval through their online platforms.

When you request permission your brokerage asks a series of questions pertaining to your

income, net worth, investing goals and level of trading and investing experience. The answers

you provide to these questions dictate, first, whether or not you receive approval to work with

options and, second, the level you can begin trading at.

It’s rare for a brokerage to deny a customer Level Zero approval, which, at most firms includes

covered call writing. To conduct all of the strategies highlighted in this eBook (covered calls,

long calls, long puts, cash-secured put writing/selling), you must secure Level One approval,

which includes all of the above, plus additional types of trades I will not cover.

Check with your broker for specific details, but it’s most likely in line with what I describe, which

is the protocol Charles Schwab employs.

“Moneyness”

After you learn some of the jargon alongside basic definitions and concepts and receive options

approval from your broker, you, obviously, need to decide which contracts to buy. One of the

biggest challenges surrounds whether or not you purchase in-the-money, at-the-money or out-

of-the-money calls and puts.

Before I get specific about moneyness vis-à-vis basic option strategies, I define what it means,

practically, for beginning options investors.

At-the-money: Strike price of option contract is same as the market price of the underlying

stock. For example, if AAPL trades at $400, both a $400 call and $400 put reside at-the-money.

The next move or series of moves the stock makes determine the fate of your position.

In-the-money: When the strike price of a call option is below the market price of the underlying

stock, the contract is in-the-money. For example, if AAPL trades at $400, an AAPL $390 call

resides in-the-money.

When the strike price of a put option is above the market price of the underlying stock, the

contract is in-the-money. For example, if AAPL trades at $400, an AAPL $410 put resides in-the-

money.

Out-of-the-money: When the strike price of a call option is above the market price of the

underlying stock, the contract is out-of-the-money. For example, if AAPL trades at $400, an

AAPL $410 call resides out-of-the-money.

When the strike price of a put option is below the market price of the underlying stock, the

contract is out-of-the-money. For example, if AAPL trades at $400, an AAPL $390 put resides

out-of-the-money.

I use moneyness almost solely to decide which option contract I will buy. Of course, the

situation – expected move, duration, company story, amount of capital available, my goal etc. –

dictates whether I choose an at-, in- or out-of-the-money call or put.

Many options investors use moneyness to guide decisions about exercising options. When you

exercise an option, you choose to buy or sell 100 shares of the stock that underlies your option

contract at its strike price on or before its expiration date for each call or put you hold. The

other major factor that contributes to this decision is your break-even point.

Consider this example. With Netflix (NFLX) trading at $69.29, you bought a NFLX March 2012

$70 call for $9.55. In this case, your break-even point on the trade is $79.55. Once NFLX hits

that price, you can exercise your option and breakeven. Here’s the math.

It cost you $955, excluding commissions, to enter the position.

100 shares of NFLX at $70 costs $7,000, but you have to make up the $955 worth of premium it

took to buy the right to purchase 100 shares of NFLX at $70, regardless of its market price. At

$79.55, 100 shares of NFLX sports a value of $7,955. You break even because it cost you $7,000

to buy 100 shares of the stock (remember, you get to buy it at the strike price of the contract,

not the current market price) and you paid $955 for the option. $7,000 + $955 = $7,955.

Of course, you want to do better than breakeven. As such, to profit you need to make a habit of

exercising not only in-the-money options, but in-the-money contracts with premiums that

exceed your break-even. With that in mind, you have to decide when it makes sense to exercise

an option. If NFLX hits $90, you make a considerable profit by exercising your option, assuming

you turn around and sell your 100 shares immediately.

$7,000 + $955 = $7,955. Value of investment at $90 = $9,000. Potential profit = $1,045.

Even though you would realize a net loss on the overall trade, you still want to exercise in-the-

money options before they expire. If you’re not past break-even, you want to wait until the

contract’s expiration date to get past or as close to break-even as possible. Your brokerage will

automatically exercise options that are in-the-money by $0.01 or more at expiration, unless you

instruct them otherwise.

In the above example, let’s assume you exercise the NFLX call with the stock trading at $75. The

party who sold you the call must sell you 100 shares of NFLX at $70 per share. Your total cost to

enter the trade is $7,955, however, the value of your 100 shares of NFLX is just $7,500. In this

case, you could sell immediately, take the loss and move on or you could hold your shares

hoping for further price appreciation.

Because I never have and likely never will exercise an option, this represents most of what I will

say on the subject. I only cover taking ownership of a stock via an options play when I discuss

writing cash-secured puts. In that situation, you don’t exercise an option; somebody else does

and you get “assigned.” Instead, I focus on buying and selling option premiums with the same

goal that goes alongside most stock trades – capital gains.

Section 2: Options As Investments Generally, beginners and intermediate-level investors use options to generate income,

speculate for profits and hedge against risk. Each of these goals can work, in conjunction with

stocks, as part of an investment strategy.

You can use options as relatively short-term vehicles for income, speculation or a hedge and

not slap the tag “trader” next to your name. If you focus your options strategy on income

generation; mid-term, reasonable speculation through the use of long-dated options (options

with expiration dates several months to more than two years out); and insurance, you can

actually be more conservative and, in some respects, take on less risk via options than you do

with stocks.

It’s little more than a misnomer that options have no place in the portfolios of new, ardent buy-

and-hold or even conservative investors. In fact, I argue that you hold yourself back by not

using options in a variety of, albeit, relatively basic ways.

Protection

I start with protection – using options as a hedge or insurance – but it’s an area I will not cover

beyond here, primarily because I do not believe in it as part of most long-term investment

strategies. Just because I do not use or endorse the strategy does not mean it’s unworthy of

your attention. I would just do disservice by getting too deep into areas I am lukewarm on at

best.

You can use options as protection in several ways. Here are the most common:

*Buying and regularly holding a put on a broad index, such as the SPDR S&P 500 (SPY) or the

PowerShares QQQ Trust (QQQ).

If you are an investor who is, by and large, long the stock market, you might entertain holding

an index ETF put to hedge against everything from a market crash to a bear market. Imagine a

portfolio that is long DOW stocks, SPY (or an equivalent mutual fund) and an assortment of

tech, retail and consumer product stocks. When the market gets hammered or goes bearish for

a while, you’ll see a glimmer of green because, if properly played in terms of strike price and

expiration date, your SPY or QQQ put should be up. But, in the most direct sense, this is

insurance because you pay a premium to include it as a holding.

I do not see this as a constant, blanket strategy, particularly for long-term, buy-and-hold

investors. If you’re so averse to the risk of on-paper losses, the answer does not necessarily sit

in dropping $900 a quarter on a SPY put that you will have to manage closely to ensure it

retains value and does not end up expiring worthless.

If you see market headwinds and you want to buy index puts as a short-term trade, go for it.

But that’s much different than keeping them in your back pocket most of the time. I would

much rather make bearish bets on individual stocks, sectors or regions alongside the realization

that losing money – on paper and for real – will always be an inherent part of investing, no

matter your goals or time horizon.

*Hedging a long or short stock position with a put or call.

This is pretty simple. You are long 100 shares of AAPL so you hold a put against it. Or you are

short 100 shares of AAPL and you complement it with a call option. Here’s another case of

trying to win twice. It’s just not for me. I would rather manage my initial conviction as best as

possible to avoid losses I cannot easily absorb instead of eating away at profits with a

potentially expensive hedge. Market makers hedge this way all of the time, but I presume most

of us reading this eBook – and getting something from it – do not fall into that category or have

the same strategic concerns.

That said, there is something to be said for leveraging a long or short position by selling calls

and puts or executing option spreads in conjunction with it. Most of these strategies go beyond

the scope of this eBook. Covered calls, however, which I discuss in the next section, do not.

They can act as a hedge as well as an income generator in portfolios of all types and sizes.

Beyond covered calls – and this is strictly my opinion – the cost and resources expended to

routinely hedge holdings using options in portfolios with long-term time horizons outweigh the

rewards.

Growth and Speculation

This is about as straightforward as it gets, yet it takes most investors lacking options experience

a while to come around to the way of thinking. You can play a stock’s growth potential or

speculate over various time horizons using options and take on less risk than you would with

stocks.

In the simplest terms, you spend much less capital to buy one option contract than you would

100 shares of a stock.

Consider AAPL trading at $405 a share. It costs roughly $40,500 to buy 100 shares of the stock.

That’s cost-prohibitive for many investors. You could attempt to profit from price appreciation

in AAPL, however, for a fraction of the cost using call options. For instance, at $271.00, a deep

in-the-money AAPL January 2013 $135 call option costs $27,100. An at-the-money AAPL

January 2013 $405 call sets you back roughly $5,876. And an out-of-the-money, AAPL January

2013 $450 call costs approximately $3,950. (Prices, as of late December 2011).

Using puts to profit from the price decline in a stock decreases your risk exposure even more. In

fact, most investors, particularly beginners to intermediate-level, should probably never short a

stock. While opening a margin account sounds like the next logical step in the progression of a

serious, albeit relatively small investor, I don’t subscribe to the belief. Too many bad things can

happen on margin.

If you get a margin call while short 100 shares of AAPL, you need to deposit more money in

your account or sell existing positions. If you don’t act fast – and your broker does not have to

wait around for anything, including the clearance of your funds – your broker trims, or sells all

together, seemingly random holdings. I’ve never had a margin call happen to quite that extent,

but even the much less-stressful, quickly-and-easily-resolved ones I have experienced create

unnecessary anxiety. I rarely use margin; and when I do, I reserve it for short-term trades,

usually lasting no longer than a few minutes to a few hours.

The next logical step after comfort with a cash account invested in stocks, ETFs and mutual

funds should be options. Covered calls first. Long calls and puts second. Cash-secured puts

third. The next several sections cover these strategies; for now, I tackle things from a more

general perspective.

If you bet against AAPL with a January 2013 $400 put, you spend about $5,500 for one contract,

as of the end of December2011. Of course, you run the risk of time running out, AAPL surging

higher and your put option expiring worthless. In this doomsday scenario, you lose roughly

$5,500. In my world, that’s better than stretching yourself thin with a five-figure margin play

that could push many investors to the limit of margin maintenance requirements.

I must step back from speaking about general situations. While that approach works best to

teach concepts and such, it ignores the nuance that influences practically every investing

decision.

First, if you are of sane investing mind, you’re really not “risking” $5,500 on an AAPL January

2013 $400 put. That’s how much cash you put up to enter the trade, but you should not call it

your risk. I cannot even suggest what your risk level “should” be. It varies by investor. Myriad

factors, ranging from account size to level of confidence in the trade, dictate how much you

actually risk. So, back to being general…

If I have a $100,000 portfolio and spend $5,500 of it to get into the above-mentioned AAPL put,

I need to decide how much money I am comfortable losing if the trade moves against me.

Related to that, I need to determine, based, partially, on the strength of my conviction, how

long I am willing to wait, and incur more on-paper losses, for a bad trade to turnaround. It’s

next to impossible to answer the second concern without moving too far away from the point

of this book. The first concern, however, is relatively simply to deal with.

Maybe I am okay with losing 2%, or $2,000, of my portfolio’s $100,000 value. In that case, I set

a stop loss on my AAPL put trade, limiting the amount I can lose on it to $2,000. Therefore, I am

not risking $5,500, but $2,000. Of course, with this type of stop loss set, you do run the risk of

the option trading down through it. For example, you go to bed at night even, but major news

breaks after the bell causing AAPL to surge at the open the next day and cut the value of your

option in half. While the odds are in your favor that this will not happen, you must be mindful

that it can. Of course, you can get caught the same way – and, in my opinion, in an even worse

way – when you’re short in a margin account. You can also successfully execute a similar stop

loss on a short sale, but, again, I consider the stakes much higher.

One more real-world consideration to ponder. I use a lot of 100 shares of a stock in my

examples because (A) that’s a common size investors trade in or think of and (B) it equates with

one option contract. If you read my work on Seeking Alpha, however, you know that I am a

proponent of buying a small number of shares in strong companies with high stock prices rather

than giving into the allure of owning a large number of shares in low-priced stocks floated by

relatively weak firms.

Be mindful that the stocks I mention in this eBook are not recommendations; rather I use them

simply for illustration purposes. That said, I see lots of good sense in an investing plan that

involves dollar-cost-averaging into high-priced stocks such as AAPL, Google (GOOG) and IBM

(IBM) on a regular schedule, buying just fractional or a small number of shares in each trade. I

have two Sharebuilder accounts as well as several direct purchase DRIP (Dividend Reinvestment

Plan) accounts where I do this with several stocks, both dividend payers and outright

speculations. For some investors, it makes no sense to even bother messing with options;

they’re better off sticking to some form of the aforementioned type of plan. That said, once

you build a portfolio with several relatively large positions, you do miss out by not taking the

time to learn and properly use options.

●

The next section of this eBook deals with income generation in the form of covered call writing.

Later, I discuss cash-secured put writing, another way to generate income with options.

Endpoint – when used as part of a careful and disciplined strategy, options present no more risk

– and possibly less – than stocks. Plus, options provide more versatility than stocks both as

standalone investments and as complimentary to stocks. You can protect other investments

using options, speculate on growth and stock price appreciation and generate meaningful

amounts of income.

I only consider options investments within the context of the “careful and disciplined strategy” I

have just begun to outline. If, in December 2011, you buy a January 2012 call or put on AAPL,

you’ve made, for all intents and purposes, a swing trade. There’s nothing wrong with that. I do

it from time to time. But, at day’s end, it’s pure speculation. More than that, though, even if

you’re somehow certain of the direction AAPL – or any other stock for that matter – will move,

you have put too many obstacles in front of your trade’s chances of success due to the short

time to expiration of your option.

With options that expire within weeks or 2 to 4 months, one of the biggest factors you have

working against you is the concept of time decay. This is where I hope my text differs from

others on the subject. In options, too much information – too fast, too complex and too cute –

can be bad. Why concern and confuse yourself with inherently complicated topics when you

can effectively ignore them by adhering to a gameplan where they are less likely to come into

play, if at all?

Time decay is a pretty simple concept to understand. It ties into the time value or time

premium of an option contract. If you think AAPL will cross $420 sometime soon (with it trading

at $405 in late December), you have to decide exactly which option you should use to try to

capitalize on that theorized eventuality. I get into strike prices later, but for the purpose at

hand, we’ll decide to play it with a slightly out-of-the-money $430 call.

In December 2011, generally speaking, the January 2012 version of the AAPL $430 call will cost

less than the February 2012 version and much less than every available month that follows. As

of this writing, the AAPL January 2012 $430 call trades for $2.99, the February $430 for $8.75,

the July $430 for $29.30 and the January 2013 for $47.50. Why the discrepancy?

All else equal, there’s a better chance AAPL will cross $430 in one year or in seven months than

it will in a few weeks or a couple of months. Therefore, you pay a larger premium on the

options where time helps increase the probability that AAPL will approach and pass $430.

Generally speaking, time decay begins to meaningfully impact option premiums with roughly

two months to go to expiration. Inside one month to expiration, the premium drops

precipitously.

Because I do not exercise options, I do not even need AAPL to hit or cross $430 for my trade to

win, as long as I buy myself enough time. And that’s the key phrase – “buy myself enough

time.” I pay a premium for time, but I also make more of an investment in Apple’s future

growth than I do when I speculate that the stock will rapidly surge to $430 inside of a few

weeks or a couple months. While a considerable number of people who use options will not

agree with this statement, it’s the one thing I hope readers take away from this eBook, if

nothing else sticks.

Never buy a long call or put with less than 4 months to expiration; ideally, give yourself a

minimum of six months’ cushion.

That statement applies within the context of this eBook, which is aimed at options beginners

looking to add options to their investment strategies for protection, appreciation and/or

income with limited risk. It applies to individuals who seek to use options more like investments

than speculative swing trades. And it serves my desire to eliminate as many of the variables

that can complicate an options investment as possible. People often talk about removing all

negativity and negative people from one’s life; in options investing, remove as much

“negativity” (e.g., time decay, sinking implied volatility, etc.) as you can from your trades.

Of course, this “rule” only holds for use with long calls and long puts. You play a completely

different game, with different goals and objectives, when you sell cash-secured puts and write

covered calls.

Section 3: Writing Covered Calls It makes sense for options beginners to start with covered calls not only because they present

the least room for disaster (e.g., losing your entire investment), but because they help inform

the process of buying long calls and puts.

When you buy an option, you are long. For example, if you buy an AAPL $430 call, you are long

that contract. When you sell an option, you are short. For example, if you sell (also called write)

that AAPL call, you are short an AAPL $430 call.

Going long an option contract results in a debit to your account. You pay to buy the call or put,

while an opposing party sells you the call or put and receives a credit in her account. Of course,

you can be on the selling end, taking the credit by selling another party the right to buy or sell

100 shares of a stock that underlies a call (buy) or put (sell) on or before the contract’s

expiration date.

When you sell an option contract, you are bound by its terms for as long as you are short the

contract. If the party that holds the contract you sold decides to exercise the option, you must

deliver the goods. If you are short a put, you must buy 100 shares of the stock that underlies

the option for each contract you sold at the contract’s strike price, regardless of the stock’s

market price. This is because the buyer can exercise his right to sell the stock – to you – at the

strike price.

*Example: You are short an AAPL January 2012 $390 put with AAPL trading at $405. Another

way to state it – you sold an AAPL January 2012 $390 put. At this point, it makes no sense for

the party who bought that put to exercise. Why sell 100 shares of AAPL at the strike price of

$390 when it costs $405 a share to buy them at market?

*AAPL trades down to $360 at some time on or before the January 2012 expiration. While

there’s no guarantee you’ll get assigned (have to deliver on the contract) at or before

expiration, you probably will on expiration day, if not before. In the event of an assignment, you

must buy 100 shares of AAPL for $390 per share, even though the stock sports a market price of

$360. The put buyer, meantime, sold you the shares for $390 after picking them up for $360. In

isolation, on-paper, you lose $3,000. I’ll get a bit deeper into this in the sections on long puts

and cash-secured put writing.

If you are short a call, you must sell 100 shares of the stock that underlies the option for each

contract you sold at the contract’s strike price, regardless of the stock’s market price, if the

party that is long the call exercises his right to buy 100 shares of the stock at the contract’s

strike price.

*Example: You are short an AAPL January 2012 $430 call with AAPL trading at $405. In other

words, you sold an AAPL January 2012 $430 call. At this point, it makes no sense for the party

that bought the call to exercise. Why buy 100 shares of AAPL at $430 a share when it costs just

$405 apiece to buy them at market?

*Obviously, the call buyer purchased the call on the basis of the conviction that AAPL will trade

towards $430. In this case, the call buyer can unload the premium without exercising the option

and profit on the option trade. Maybe the call buyer made the purchase intent on exercising

once AAPL hits $430, passes it and surges ahead of his breakeven point on the trade.

*AAPL appreciates to $450 a share at some time on or before the January 2012 expiration. In

the event of assignment, you’ll need to sell the call holder 100 shares of AAPL at $430, even

though AAPL trades for a market price of $450.

Here’s where the distinction between a naked call and a covered call comes into play.

With a naked call, you do not own shares of AAPL to support (“cover”) the call you sold (are

short). In the above-described scenario, things did not work out too well for you as a call seller.

You would have to buy 100 shares of AAPL at its $450 market price for every contract you are

short and then turn around and sell them to the call buyer for the contract’s strike price of

$430. That, in isolation, represents a loss of $2,000 per 100 shares.

I say “in isolation” because when you sold the call you received a credit that is yours to keep.

That credit partially offsets the cost of delivering on the call contract. For instance, if you

received a $3.00 ($300) credit when you sold the call that makes the effective price of the AAPL

shares you had to buy $447, reducing your loss on the trade to $1,700.

If, instead of writing a naked call, you owned 100 shares of AAPL and wrote a covered call, the

situation, while not necessarily a good one, would likely not be quite so difficult to bear. Of

course, this all depends on the particulars of the situation. Consider the following possibilities.

*Way back when you had the foresight to buy AAPL at $100 a share. You write the above-

mentioned $430 call against 100 of your AAPL shares. The stock surges to $450. You get your

shares called away. You have the credit you collected from selling the call in the first place, plus

a $33,000 profit on the sale of the stock. ($43,000 proceeds minus original cost basis of

$10,000). Sure, you miss out on about $2,000 worth of profits with AAPL trading at $450, but

you likely will not lose much sleep over that given your hefty five-figure gain.

*In some strange world, you bought AAPL at its all-time high of $600. With the stock close to

$400, you have kept the faith, holding tight to your shares. While you wait for AAPL to rebound,

you want to generate some income to ease your on-paper losses so, with the stock at $405, you

sell this running example’s $430 call. You did not expect AAPL to surge to $450, but it did and

you did nothing. You have your shares called away. You must sell them for $430, which results

in a considerable loss of $17,000 (original cost basis of $60,000 minus $43,000 in proceeds from

the sale).

As you watched this situation unfold, you could have moved to stop your shares from getting

called away. With AAPL heading up to the $430 strike price, you could have bought the call

back. Remember, you sell to open to initiate a covered call (or buy-write, as in simultaneously

buy 100 shares of the stock for each call you write) and then buy to close if you wish to close

the call position. The problem here is that, given AAPL’s upward movement, you would likely

need to buy the call back at a higher premium than you paid for it. While you take a loss on that

option trade, it pales in comparison to the loss you take in the event your shares with the high

cost basis get called away.

It’s important to note that if you move to buy back a covered call, you need to do it before the

call holder assigns you (calls your shares away). If you do not move fast enough, you might see

your shares called away despite your desire to close the position. On the other hand, some

investors get worried, act too soon and buy back a covered call only to see the stock pull back,

creating a situation where their shares likely would not have been called away after all.

These two somewhat extreme examples highlight the importance of closely managing the

entry, trajectory and worst-case scenario exit plan when you write covered calls. Most of the

time, covered call writing ends up a stress-free proposition that generates income and bolsters

your portfolio’s overall return.

The best way to get a handle on how you can work covered calls into your investing strategy is

to run through several different types of less-intense examples.

Example #1

You own 500 shares of General Electric (GE) in an IRA. You bought them for $10.78 each back in

July 2009. With the stock approaching $18.00 in December 2011, you decide it’s time to bail

and bank some profits. While you could just place a limit order to sell at $18.00 and wait for it

to hit, you could write covered calls to squeeze bigger profits out of the trade.

You could write five GE January 2012 $18 calls, collecting $0.16 each for a total credit of $80.

Because January expiration is so close, time decay has chipped away at the value of those

slightly out-of-the-money $18 calls. To make the endeavor more worthy of your time (and

commission charges), you could opt to sell five GE February 2012 $18 calls, collecting $0.67

apiece for a total credit of $335. That pretty impressive; in fact the $335 credit rivals the

roughly $340 worth of dividends GE paid out on 500 shares in 2011, based on its December

31st, 2011 stock price and payout information.

No matter what happens in a covered call situation, you keep the credit you received for

writing the call(s). If your GE shares get called away, you keep the credit and cap your capital

gain on the stock trade at $3,610.

-You paid $5,390 for 500 shares of GE at $10.78 in 2009. If they get called away, you must sell

them for $18 per share ($9,000 in proceeds), regardless of their market price. In isolation, that

represents a $3,610 profit.

What’s your risk here? It’s no different than what I brought up in the previous, albeit more

extreme and stressful AAPL examples. If you have $18 calls written and GE soars to $22, you

miss out on $4 worth of profit. While that can sting, it’s not necessarily direct money lost. I’m

not going to get into buying the calls back for two reasons – (1) There’s no guarantee you will

be able to and (2) It’s not good practice to salvage covered call trades by buying back escalating

premiums.

When you execute a covered call, you should go into the trade feeling good about the premium

received on the calls and comfortable with the price you’ll need to sell your shares at if they get

called away. This is where discipline comes in. You wrote the calls and generated $335 worth of

income. You determined that you were good with a 67% gain over 2.5 years on 500 shares of

GE stock. You did well. Don’t fret over the $4 you left on the table. Disciplined investors

understand that for every trade they close under these circumstances to save face, there will be

others where it ends up that you never needed to close the trade.

Put another way, do not allow the fact that GE ran sour you on agreeing to sell your shares for

$18 each. Again, ensure you are 100% good with that strike price at the outset. Envision a

scenario where the stock runs (or consider the prospects and likelihood that it could) and try to

imagine how you would feel. If that situation would trigger angst, don’t sell the $18 call.

Ratchet up the strike price you sell the call at to a level where the return on the underlying

stock trade keeps you content. You can always use another strategy in conjunction with this

position…

Example #2

If you do not want to let go of your GE shares, but seek to maximize the income they generate,

you can write a series of covered calls. When the first set expires, write the next set and so on.

To do a better job protecting your shares, select further out-of-the-money strike prices.

Depending upon the schedule of expiration dates you use, you might take in less income, but

you decrease the likelihood of having your shares called away.

In late December 2011, for example, you could write five GE March 2012 $20 calls and collect

$0.18 per contract for a total credit of $90. If you manage to replicate this at right around the

same premium three to four times per year, you have come close to, if not doubled, the income

you receive from ownership of 500 GE shares.

Example #3

Though I am not sure I will ever understand why, some AAPL shareholders are unhappy that, as

of the end of December 2011, the company does not distribute a dividend. If you own 100

shares of AAPL, you can do a formidable job generating consistent income on your own. With a

stock like AAPL, you can go quite a ways deep out-of-the-money with your call writing and still

collect meaningful income.

With AAPL trading at $405 at the end of 2011, the February 2012 call options sport juicy

premiums. The $410 call fetches roughly $16.55, the $415 call $14.25, the $420 call $12.20, the

$425 call $10.40, the $430 call $8.70, the $435 call $7.30, the $440 call $6.00, the $445 call

$4.90 and the $450 call $4.00. If you’re weary of having your AAPL shares called away, you can

sell deep out-of-the-money calls, collect a hefty premium and rest assured knowing that, in the

event your shares get called away, you’ll receive a more than fair price for them.

●

It does not get much more straightforward in the options world than writing covered calls. You

cannot say the same, however, in relation to long calls and puts and writing cash-secured puts.

Section 4: Long Calls And Puts

Hopefully, you have a reasonably strong understanding of what a call option is and what it

means to be long a call option. By going over covered call writing first, I think we help

accomplish this goal.

In summary, a call option gives the buyer the right, but not the obligation, to buy 100 shares of

the option’s underlying stock at the contract’s strike price on or before the contract’s expiration

date. For example, if you purchase an AAPL January 2013 $500 call, you have the right, but not

the obligation, to buy 100 shares of AAPL for $500 per share on or at any time before options

expiration day in January 2013.

If you spent $23.85 on that AAPL call, you have a break-even price of $523.85, meaning that

when AAPL trades to that level, you are at break-even on the position. In other words, if you

exercised the option to buy 100 shares of AAPL at $500 with it trading at $523.85, you break

even – no profit, no loss (excluding commissions). If you exercise the option with AAPL trading

higher than $523.85, you begin to profit. Of course, you could take ownership of the stock,

theoretically, at any level. You do not actually realize a gain or a loss until you sell the shares

you obtained via an option exercise.

I do not have to run through the same detail regarding puts; by now, it’s likely clear that they

run in the inverse to calls. You can simply take much of what I say about calls and turn it around

to suit puts. When that’s not the case, I specifically reference one or the other.

Because I do not use long options plays to buy or sell stock, I focus this section on how you can

handle your actual long call option position, meaning how can you profit from rising premiums

and avoid the pitfalls that go along with deteriorating, on their way to worthless premiums?

●

At this point, the most crucial takeaway from this eBook comes into play:

Never buy a long call or put with less than 4 months to expiration; ideally, give yourself a

minimum of six months’ cushion.

Again, consider the context of this statement. This eBook applies, primarily, to relatively small

investors with a desire to safely and effectively work the use of options into their overall

investment strategies. I do not consider how to manage short-term options trades because,

even for experienced options traders, that’s difficult to do. Complicating factors come into play

the closer an option contract is to expiration. Therefore, I strive to eliminate, or at least

marginalize, those concerns.

For instance, I do not pay much attention to implied volatility in this eBook. Implied volatility,

along with the underlying stock’s market price and other factors, helps set the price of an

option contract. Implied volatility measures the expected or estimated volatility of a stock or

other security’s price. Implied volatility reflects the expected volatility – or price movement – of

a stock over the duration of an option contract.

As demand for particular options rises and expectations for the underlying stock intensify,

implied volatility rises. This is why implied volatility tends to increase on options contracts

ahead of earnings or other events where the market anticipates considerable

movement/volatility in the underlying stock. This phenomenon provides the answer to a

question I raised at the outset of this book.

I often get queries from Seeking Alpha readers asking why the calls they bought on a company

ahead of earnings lost value or stagnated post-earnings, even though the company blew away

estimates and its stock price followed. Implied volatility provides the explanation. Simply put,

once the expected move on earnings takes place, generally in after-hours trading and on the

next trading day, implied volatility swoons as expectations for the stock stabilize. This sucks the

life out of options premiums.

Generally, you make hay selling options contracts (writing covered calls and cash-secured puts)

when implied volatility is high and about to tank. You can never be certain when this ebb and

flow will take place, but earnings-related IV and premium tanks tend to be somewhat reliable.

By avoiding options with near-term expiration dates, you effectively neutralize the effects of

implied volatility as well as time decay. As I noted earlier, the longer the time to expiration,

generally the more you pay for the option contract. Often times, cheap options are little more

than sucker’s bets. That brings us to key takeaway number two:

Avoid or, at the very least, exercise extreme caution with options that are cheap because they

expire soon or are out-of-the-money.

The same type of psychology lures traders and investors into cheap options as it does cheap

stocks. First off, “cheap” is the wrong word. Just because something comes with a low price tag

does not automatically make it inexpensive. I think nothing of spending six or seven bucks for a

Guinness in a bar, while passing up the $3 Coors Light happy hour special. For me, it’s less

about the endpoint of getting a buzz and more about the quality of the experience that takes

me there.

Avoid or, at the very least, exercise extreme caution with options that LOOK cheap because

they expire soon or are out-of-the-money.

Often, good reasons exist to explain a stock’s low price. There’s something fundamentally

wrong with the company, its balance sheet, its share structure or all or some combination of

the above. In many cases, you stand a greater chance turning a profit on a smaller number of

shares of a relatively high-priced stock than you do on a large lot of a low-priced, but somehow

flawed one.

An option often sports a low price because the probability of it doing what it needs to do to

make you money on the trade is low… or at least lower than other available and, presumably,

more expensive options. It’s probably one of the easiest options concepts to understand, yet

it’s where so many investors who use options go wrong.

In January, you pay less for the right to purchase 100 shares of AAPL at $450 in February when

it’s trading at $405 than you do in December because it’s less likely that AAPL will make that

move in a month and more likely that it will make that move in 12 months. You pay less for the

$500 call than you do the $450 call, in any month, because the chances that the $450 call will

be in-the-money at expiration are greater than the chances that the $500 call will be.

You often hear options’ types reference “lotto tickets.” When they do, they’re speaking of

options with a relatively short time to expiration, deep out-of-the-money strike prices or both.

It’s akin to taking a flyer on several thousand shares of a sub-$5 stock instead of one hundred

shares of a $300 stock. Despite slim chances of success, investors, all too frequently, opt for

more shares or more contracts on plays that amount to hail Mary passes.

I don’t want to go there, other than to say don’t do it anymore than you would throw your

money on red at Mandalay Bay or put a sawbuck on Captain Nemo in the third at Belmont.

Instead, as part of an investment strategy, I advocate the use of long calls to make just about

the same prediction on the trajectory of a stock using options as you would with the stock

itself, but for a fraction of the cost or for added exposure to the equity.

Delta

One of the most important factors to consider when going long an option is one of the options

Greeks – delta. In my opinion, when you take time decay and implied volatility out of the

picture (or decrease their impacts), delta becomes the most important factor to consider.

Delta is a relatively simple concept. Holding all else constant, delta measures how much the

theoretical price of an option contract will move relative to a $1 change in the option’s

underlying stock.

Delta can be positive or negative.

Positive delta: Option premium increases as the underlying stock price increases; premium

decreases when the underlying stock price decreases (e.g., long calls, short puts).

Negative delta: Option premium increases as the underlying stock price decreases; premium

decreases when the underlying stock price increases (e.g., long puts, short calls).

A call option’s delta ranges from 0.00 to 1.00. A put option’s delta ranges from 0.00 to -1.00.

If your ZZZ January $10 call has a premium of $1.00 and a delta of 0.50, a $1 pop in the stock

price, theoretically, triggers an increase in the call’s premium to $1.50. A $1 decrease in the

stock price, theoretically, brings the call premium down to $0.50.

If your ZZZ January $10 put has a premium of $1.50 and a delta of -0.75, a $1 pop in the strike

price, theoretically, triggers a decrease in the put premium to $0.75. A $1 decrease in the stock

price, theoretically, prompts the put premium to increase in value to $2.25.

It’s important to note that the math behind delta is not hard and fast. First, plenty of other

variables can impact delta, ranging from implied volatility to time decay. And, somewhat

obviously, delta changes. Another Greek, gamma, measures the stability of delta. Gamma

estimates how much delta changes per a $1 move in the underlying stock. The bigger the

gamma, the bigger the change in delta, even when the underlying stock only makes a small

move.

Generally speaking, an at-the-money option has a delta at or around .50. The deeper in-the-

money an option contract, the closer the delta on a call is to 1.00 and the closer the delta on a

put is to -1.00. The deeper out-of-the-money an option contract, the closer the delta on a call

or a put is to 0.00.

Volatility and the amount of time remaining to expiration impacts delta. Here are some general

points to consider:

*The deeper in- or out-of-the-money an option is, the more delta reacts to changes in volatility

and time to expiration.

*As the number of days to expiration and volatility decrease, in-the-money calls move closer to

a delta of 1.00 (puts to -1.00) and out-of-the-money calls and puts move closer to a delta of

0.00.

*At-the-money options, regardless of time to expiration and volatility, tend to have deltas

closer to .50.

This all sounds great, but what does it mean, practically, for the options investor?

If you aim to use options to replicate ownership in a contract’s underlying stock, seek out

contracts with high, rather than low delta. While options provide a cost advantage over stocks

(it costs less to buy one contract than 100 shares of the underlying stock), that reality is not

created equal, so to speak. You have to factor in the odds of the prediction you’re essentially

making.

And this is where you benefit by keeping it simple. You do not need a bunch of fancy math

thrown at you to understand common sense concepts. Setting delta aside for moment, think

back to the core concept of buying yourself enough time to expiration and limiting the space

between the strike price on calls and puts that you buy and the market price of their underlying

stock.

Theoretically speaking, the closer the strike price you select is to the market price of the

option’s underlying stock, the better your chances of a profitable trade. Also, the more time

you give yourself to expiration, the more likely it is that the underlying stock will near, reach or

surpass the strike price you select. This is not say you should never buy out-of-the-money

contracts or even close-in options; rather, you must realistically consider the chances of what

you need to have happen taking place.

If you’re looking at AAPL options with the stock trading around $412 on the first trading day of

January 2012, you increase your chances of making a profitable call by looking beyond the

current month. If, for some reason, you feel the need to use January calls, you’re clearly much

better buying something in- or at-the-money as opposed to out-of-the-money. Ignoring, for the

sake of argument, the idea of a near-term pullback from the stock’s highs, the same applies to

puts. Again, consider these examples generally, not as specific trade ideas. I’m going over broad

concepts here, not actual trades.

For reasons already established, the AAPL January 2012 $420 call, at $6.70, costs less than the

$410 call at $11.20. The difference in delta between the two is also relatively large, at .386 (for

the $420 call) and .541 (for the $410 call). You do not start moving really close to a delta of 1.00

until you hit the $385 strike, which sports a delta of .8394. You start seeing what effectively

amounts to deltas of 1.00 in the lower-to-mid $300 strikes.

Bottom line – If I have to use January options to play by bullish or bearish conviction on AAPL, I

am doing it with at- or in-the-money, not out-of-the-money options. Admittedly, you will miss

out on some great out-of-the-money hits you could brag to your friends, but, if you want to use

options as part of an investment strategy, you need this type of discipline.

Consider the price action of the above-mentioned January calls on the day I am looking at here.

When I pulled the quotes, AAPL was up by roughly $6.50 on the day. The January 2012 $420 call

was up about $1.30 and the $410 call was up approximately $2.30. Both produced similar price

increases at that point of the day, percentage-wise, of about 25%. From here, in both cases,

you need the rally to follow through to make similar hay. That said, you’re likely better off with

the in-the-money call because if the rally fizzles or falls short of $420, its value will deteriorate a

bit more slowly than that of the out-of-the-money contract. Plus, the in-the-money call

possesses the intrinsic value the potentially, soon-to-be worthless out-of-the-money call does

not.

As a disciplined trader, I would spend $1100 on one $410 call, not $1300 on two $420 calls.

You’re not getting a bargain taking the price “discount” for buying two over one. As an investor

looking to use options more like investments, I would not buy any AAPL option at any strike on

either the call or put side. Doing so hardly echoes investing, it’s truly where options deserve the

otherwise unfortunate stereotype that they’re akin to gambling.

If I believed in AAPL’s near-term and long-term future, I would look to slightly out-of-the-money

calls with expiration coming no sooner than June 2012. As an investor, if you bought the stock, I

don’t think you would do it with the expectation that it would catapult from $412 to $420 or

$425 within two to three weeks, particularly after such a nice short-term run. With that in

mind, why would you make an options investment that basically requires the same thing to

take place? Thinking like an investor, you would be better off paying more and using July 2012

calls or LEAPS options.

LEAPS (Long-Term Equity AnticiPation Securities) are long-term options contracts that most

closely resemble direct stock ownership. As usual, you still have to make the right directional

bet, but you have considerably more time to be right – and ride any pullbacks – than you do

with options that expire within a few weeks or even a few months. Of course, you pay more for

this luxury. AAPL January 2013 and January 2014 LEAPS options cost even more than July 2012

contracts. But, they still cost less than owning the stock directly.

An AAPL January 2013 $410 call, for example, traded for $58.95, as of intraday, January 3, 2012.

One contract costs roughly $5,895 compared to $41,000 for 100 shares of AAPL stock. And,

when using LEAPS, you take less risk when selecting an out-of-the-money call. I cannot stress

enough, however, that you still have to be right about the direction you think the stock will

move in and realistic about how much it will move.

Lots of investors and analysts have slapped $500 – and, in some cases, much higher – price

targets on AAPL. If it did move from, say, $410 to $500 by the end of 2012, that would

represent a more than respectable 22% increase. Given AAPL’s history, it’s not crazy to think

that that could happen. But, again, I am not writing this to make specific predictions on what

individual stocks will do. Eliminate pre-conceived opinions about Apple from your mind and

think in terms of this example acting as no more than an illustration of general concepts. While

plenty of stocks go up by 22%, or more, in a year, quite a few do not. When buying options

contracts, you have to think along these lines and reign in your expectations.

Shave at least 10% off of any price projection you come up with, whether you pull it out of thin

air or get to it after hours of number crunching. I’m not going to set a hard and fast rule about

what strike price to select or what expirations, after the aforementioned 4-6 month window, to

use, other than to say, the time premium you pay to go closer to the money and further out in

time is worth it if your goal is to replicate stock ownership via options.

With that in mind, the other benefit of going with LEAPS or other long-dated options is that, if

you choose to use out-of-the-money strikes, you do not need as much price appreciation in the

underlying stock to make a profit selling to close your contract at a higher price than you

bought it for. If a stock makes big moves (volatility increases), but time decay has yet to

become a factor, your premium should rise enough for you to make a profitable trade even if

the market price of the underlying stock is still below your out-of-the-money option’s strike

price.

A similar type of logic applies to using puts to reflect bearish sentiment, however, you eliminate

even more risk with options versus shorting a stock. That’s the beauty of puts, you put up less

money to buy them than you do to borrow shares of stock and you do not have to deal with

potential margin-related headaches or pitfalls.

Section 5: Cash-Secured Puts

You have $50,000 worth of cash in your account. You want to use most of it to buy 100 shares

of AAPL. If the stock trades for $400 that level buy runs you about $40,000. You could place a

buy order and secure the shares likely without any problems.

You could also short a put to get long AAPL stock. That sounds counter-intuitive. Going short to

get long, but, with options it makes perfect sense. When you sell a put, it goes without saying

that somebody else buys it from you. But, take that reality apart. The other party is not just

buying a piece of paper, she’s buying the right to sell you 100 shares of AAPL at the strike price

of the put contract on or before expiration. And she’s paying you for giving her that right.

In this case, you want to get assigned, meaning you want the party you sold the put to, to

exercise her right to sell you 100 shares of AAPL at the strike price of the contract she holds.

If you sold an AAPL $400 put, you would need the put buyer to exercise the option so that you

get “put” (assigned) 100 AAPL shares at $400 apiece. Of course, there’s no guarantee if or when

the put buyer will exercise. You can be pretty certain that if the contract expires $0.01 or more

in-the-money that she’ll exercise (automatically) and you’ll get the shares. If the contract

expires out-of-the-money, don’t expect to get assigned the AAPL shares you were after. That’s

the biggest risk associated with selling cash-secured puts.

You could sell a $400 put only to see AAPL run to $420 and never look back. On the bright side,

you collected and were able to keep a nice credit to your account for selling the option

premium. You keep that income no matter what happens, just like covered call income. To the

down side, you must now reevaluate your plans for getting long AAPL stock and, unless there’s

considerable pullback, you missed quite a bit of upside.

The other risk, of course, is that you get assigned shares at $400 and, shortly thereafter or at or

before the time of assignment, AAPL proceeds to drop below that level. That risk, however,

applies to a straight stock purchase as well. You could buy 100 shares of AAPL right now for

$400, only to see it immediately drop below that level.

You must also factor in the premium you received for selling the put. If you sold the put for

$16.85, you generated $1,685 worth of income for yourself. You also lowered the effective cost

of your AAPL shares, if assigned, to $383.15 per share. You have not actually lost money, on-

paper, until AAPL drops below that level.

That’s as far as I will take selling puts in this eBook. I don’t think other put-selling strategies

make sense in an options eBook that targets investors looking to use options as much like

investments as possible.

Clearly, however, you’re bullish when you sell a put. Some traders and investors sell puts

without the desire to get assigned shares of the underlying stock. They want the premium

income. They want the underlying stock to rise and not look back, allowing time decay to do its

job and render the put they sold worthless.

Within this context, I also do not advocate anything other than cash-secured put selling. If you

do not have enough money in your account to cover the shares you run the risk of getting

assigned, do not enter the trade. Using margin to support a short put could result in disaster if

the stock plummets. You do not need that headache.

Acknowledgements, Resources and Disclaimers

Most importantly, I want to thank Seeking Alpha for the opportunity it provides me and the

other contributors to the site. Without the platform Seeking Alpha provides, it would not have

been worthwhile for me take the time to write and publish this eBook.

Specifically, I want to thank the always-supportive and incredibly sharp CEO of Seeking Alpha,

David Jackson, for his support. I also want to express the deepest thanks to the excellent

Seeking Alpha editorial team, particularly the people I work with directly most often – Michael

Hopkins, Mary Hunt, Yosef Levenstein and Eli Hoffman. Hardly a day goes by where I do not

interact with Michael and Mary, two people who prove, day-in and day-out, that they’re not

only the best in the business at what they do, but excellent people to boot.

To that end, I have literally learned everything I know about options from fellow Seeking Alpha

contributor Robert Weinstein. In a business where competition can be cut-throat, Bob is always

more than willing to offer me the same information and edge that makes him so good at what

he does. Bob will always know more than me about options, which is great because it means I

can continue to learn.

You would be well-served to follow Robert Weinstein on Seeking Alpha to learn more about

options and other stock market issues. Also visit his trading/investing website at

Paid2Trade.com.

By a similar token, Seeking Alpha contributor Frederic Ruffy of WhatsTrading.com has been a

constant source of knowledge and support, offering his insight just as freely as Bob.

I wrote this book with no grand plan for success in mind. I simply wanted to take the things I

feel confident about regarding options and pass them along to the growing number of investors

interested in using them. I limited the information I included in this eBook for two reasons.

First, I truly believe that it makes sense for long-term investors just starting out with options to

keep things simple and contain themselves to a handful of the most basic strategies. Second, I

would not feel comfortable discussing areas that I, myself, am not comfortable with. After all,

this involves the stock market and the stock market deals in real money.

To that end, I am not a licensed or registered investment advisor. Do not take anything you

have read in this eBook as investment advice. Rather, it’s intended for educational purposes

only. Simply put, I have passed on information in areas that interest me and that I have

personal experience in. If you make a trade using options or any other type of investment

product and gain or lose money, you assume full responsibility for that success or failure.