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TRANSCRIPT
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Copyright, 1996 Dale Carnegie & Associates, Inc.
Stock Options - Basic Strategies
For A Lifetime Of Option
Investing
The
Bull Market
Report
Seminar
Vail 99
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Introduction - The Very Basics
An option is the right, but not the obligation,
to buy or sell a stock for a specified price onor before a specific date. A call is the right
to buy the stock, while a put is the right to
sell the stock.
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Buyer and Writer or Seller
The person who purchases an option,
whether it is a put or a call, is the option
"buyer." Conversely, the person whooriginally sells the put or call is the option
"seller" or "writer."
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Contract -- Premium -- Risk
1 option contract controls 100 shares
The price of the option is referred to as the
"premium
The potential loss to the buyer of an option
can be no greater than the initial premium
paid for the contract.
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Strike Price
Strike price" or "exercise price" - the price
at which the option holder may buy the
underlying stock pursuant to a call option orsell the stock pursuant to a put option.
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Expiration Date
Expiration date" - options expire on the
third Friday of the month
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Call Options vs. Put Options
Call Options - The buyer
of a call option purchases
the right to buy 100 shares
of the underlying stock atthe stated exercise price.
Thus, the buyer of 2 IBM
May 160 call options has
the right to purchase 200shares of IBM at $160 up
until June expiration date.
Put Options - The buyer of
a put option purchases the
right to sell shares of the
underlying stock at thecontracted strike price.
Thus, the buyer of one
IBM May 160 put has the
right to sell 100 shares ofIBM at $160 any time
prior to the expiration
date.
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Strategies - Risks and Rewards
Who Buys Options?
An investor who is very bullish
An investor who would like to take advantageof leverage with a limited dollar risk
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AnE
xample In an example, ZYX is trading at 44 1/4. Instead of spending $22,125 for 500 shares of
ZYX stock, an investor could purchase a six-month call with a 45 strike price for 3 3/8.
By purchasing a six month call with a 45 strike for 3 3/8, the investor is saying that he
anticipates ZYX will rise above the strike of 45 (which is where ZYX can be purchased
no matter how high ZYX has risen) + 3 3/8 (the option premium), or 48 3/8, by
expiration. Each call represents 100 shares of stock, so 5 calls could be bought in place
of 500 shares of stock. The cost of 5 calls at 3 3/8 is $1,687.50 (5 calls x 3 3/8 x $100).
Instead of spending $22,125 on stock, only $1,687.50 is needed for the purchase of the 5
calls. The balance of $20,437.50 could then be invested in short-term instruments. This
investor has unlimited profit potential as ZYX rises above 48 3/8. The risk for the option
buyer is limited to the premium paid, which in this example is $1,687.50. Commissions
and taxes have not been taken into consideration in these examples, although they canhave a significant affect on the investor's returns.
Had the stock been purchased at 44 1/4 (a cost of $22,125), and it rose to 51, it would
now be worth $25,500. This would be a 15.3% increase in value over the original cost of
$22,125. But, the call buyer spent only $1,687.50 and earned 77% on his options.
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Strategies - Risks and Rewards
Who sells options?
1) Put Sellers
2) Call Sellers
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Strategies - Risks and Rewards
Put Writer:
An investor who would like to acquire a
position in a particular security, but is willing towait for it to trade at his desired price.
Would you rather buy CSCO today (4/5/99) for
$113 or 2 months from now for $105
(May 115 puts @ $10)
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Writing A Put
Have you ever given your stockbroker an order to buy a security at a specified
price? If you have, you have participated in a waiting game. The stock will not
be purchased until it trades at or below your limit price. Instead of waiting for
that to happen, you could have sold a cash-secured put. A premium (the price
of the option) for selling a put option would be paid to you for accepting theobligation to buy a stock that you want to be a part of your portfolio at the
price you select.
If the stock does not drop below the strike price by expiration, the premium
will be retained by the seller and another put may be sold. By selling the put,
the investor receives the premium while waiting for the stock to decline to thestrike or price at which he is willing to own it.
Therefore, the cash-secured put is a strategy that may help you accumulate
stock at a lower price than where it is currently trading (net cost = strike price -
premium).
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Strategies - Risks and Rewards
Covered Call Writer:
An investor who is neutral to moderately
bullish.An investor who is willing to limit his upside
for some downside protection.
Cash flow
NOTE: The covered call strategy may be implemented in Keogh and IRA
accounts.
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Covered Call Writing
Covered call writing is either the simultaneous purchase of stock and the sale of a call
option or the sale of a call option against a stock currently held by an investor.
Generally, one call option is sold for every 100 shares of stock. The writer receives cash
for selling the call but will be obligated to sell the stock at the strike price of the call if
the call is assigned to his account. In other words, an investor is "paid" to agree to sell
his holdings at a certain level (the strike price). In exchange for being paid, the investor
gives up any increase in the stock above the strike price.
If an investor is neutral to moderately bullish on a stock currently owned, the covered
call might be a strategy he would consider. Let's say that 100 shares are currently held in
his account. If the investor was to sell one slightly out-of-the-money call, he would be
paid a premium to be obligated to sell the stock at a predetermined price, the strikeprice. In addition to receiving the premium, the investor would also continue to receive
the dividends (if any) as long as he still owns the stock.
The covered call can also be used if the investor is considering buying a stock on which
he is moderately bullish for the near term. A call could be sold at the same time the
stock is purchased. The premium collected reduces the effective cost of the stock and he
will continue to collect dividends (if any) or as long as the stock is held.
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Credit Spreads
Credit: because the option sold is priced
higher than the option bought
Spread: because it's a purchase of oneoption and the sale of a related option on the
same stock at a different strike price
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Credit Spreads
Bearish Credit
Spreads
uses call optionsprofitable if the
stock does not
increase
significantly
Bullish Credit
Spreads
uses put optionsprofitable if the
stock does not
decrease
significantly
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Making It All Work For You!
Covered Calls & Credit Spreads
Time is on your side
Position trades
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Time and Position Trades
It is very difficult for most people over the long-term to make money buying
options on a regular basis. The main reason for this is two-fold. When you buy
an option with a month or two until expiration, you have to be right in the
direction that the stock is going to move AND you have to be right on the timing
of the move...that is, it has to move pretty soon or the time value of the option
will work against you too much.
When you sell options (ie, covered calls and credit spreads), the strategies tend
to be a little more forgiving. This is due greatly to the fact that you will have the
time value working for you.
Another benefit of covered calls and credit spreads is that they are what I referto as "position trades". That is, once you enter the covered call position or the
credit spread, generally, you don't need to watch the screen all day. Such is not
true when you are buying options. Generally, when you buy options, you want to
keep close tabs on it during the day in case it makes a run one way or another
so that you can make a move if needed. Thus, the covered call and credit
spread techniques fit in to many people's lifestyle much better than other stock
option strategies.
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Notes
Certain of of the foregoing text re-printed herein with permission from the C.B.O.E.
Copyright 1998 1999 Chicago Board Options Exchange.