Options Trading Basics by David G. Epp

October 8, 1999

Options trading and bungee jumping have a lot in common. Both can slam you into the ground ... and both can send you flying into the stratosphere. So why attempt such extreme sports? Some do it for the adrenaline rush, the thrill of doubling your money in hours or minutes.

Not all options trading is risky. Sophisticated investors may use options as a protective hedge or insurance strategy. And selling calls is not as risky as buying calls. We only have space here to very simplistically discuss Call and Put buying and selling, not call writing or sophisticated strategies. If you are trading futures, or are considering it, options trading is, for the most part, not as risky as trading futures. Your risk is limited to the size of your "bet." No margin calls here.

If you are serious about learning all the strategies possible with options trading, we recommend Lawrence G. McMillan's book, Options as a Strategic Investment. We have his third edition and find all 600 plus pages of it to be very informative and helpful.

Should you trade options? And what type of options should you trade? Where do you start if you are new to the game? And what are the basics you need to know to survive and hopefully keep the cost of tuition below that of a good business school.

Will you make money? Yes. Maybe a lot of money. But unless you are lucky or have a personal tutor, you will lose more money than you will make for the first few months. The odds are slimmer than day trading stocks where over 70 percent of day traders lose money at first. This is risk capital - not the grocery money - we are talking about. In other words, if you wouldn't take some of it to Vegas, don't trade options with it.

If you are ready to take the plunge with us, here is a very brief overview of how to begin. By far the most important advice we can give you is this: Pick one area of options trading and get very very good at it. And pick an index or stock options that has high liquidity, lots of trading volume. Start by watching the OEX or the XAU or both. You may also pick an individual stock that you follow closely. Just make sure there are hundreds, or even thousands, of options traded each day. You can find some of this information in the Options Chains (www.moneynet.com is one source, www.dingdingding.com is another source for options traders.)

Know your area of trading so well that you can remember the bid and ask prices and the options symbols by heart. Know it so well that you can tell if the market makers are giving you a fair shake on prices because you know what the last trades were. Know your market so well that you know the support and resistance levels of the stock or index by heart. You have one or two markets that you can call your own. You know them better than anyone. Only then will you win.

There is one other critical piece of advice: Don't fight the Fed and don't fight the tape. Know what the broader secular or cyclical trends are so you trade on that side of momentum. That way, if you get caught in a trade you are more likely to be correct - or at least to get out with a smaller loss. For example, what do you think? Have metals put in a bottom and the trend is up? Trade the calls when the market sells off and avoid the puts. Has the market topped out and ready to crash? Avoid the calls and trade the puts whenever the market rallies up into resistance.

What are the simple basics a beginning options trader must know? There are basically two types of options you might trade: Calls and Puts. LEAPS are simply long-term options. If a call or put option typically expires in 30 to 90 days, a LEAP might not expire for a year or two. By the way, options are traded on a number of exchanges: CBOE, American, Philadelphia and Pacific. You will get that information from the Options Chains and need to know that to place trades. And in case you weren't sure, a Call gives you to right to buy a particular stock, or index, and a Put is the opposite. With a Call you make money when the market rises. A Put makes you money only if the market or the underlying stock falls sharply in value.

What is the value of an option? Unlike a stock, an option has more risk as it is a "wasting" asset. The initial value of an option declines as time passes until it expires completely worthless - if an option has a 30 day expiry, it will be worth about 1/30 less each day you hold it. Actually, a 3 month option decays at twice the rate of a 9 month option. And options lose time value faster within the last few weeks before expiry. But the important point is this: with time working against you, you must not only be right about the direction but you must also be correct about timing. Options are the very antithesis of a "buy and hold" stock. True, like a stock, an option is a security, but it is a derivative security. Stock splits and dividends may affect the option price but the holder of a call option does not receive dividends paid to stockholders.

There are at least two components to the price of an option: one is intrinsic value, the amount by which the stock or index price exceeds the options price. The second is the premium. The premium is simply that value of time left until expiry plus any amount by which the option exceeds the intrinsic value. That can vary depending on investor sentiment and volatility. Deep in the money options may actually trade at a discount to the cheaper out of the money calls due to the percentage risk/reward ratio. You can minimize those risks and fluctuations by trading "near the money" or "in the money" options with near term expiries. And as we said earlier, get to know your one or two areas of expertise as we discussed earlier. Don't trade all over the board.

Strike Price: Options generally have prices spaced 5 points apart for smaller cap stocks and 10 points for the large caps. Smaller stocks may have strikes 2 « points or less. Stock splits may leave the options with odd fractions or decimals. Strike prices are not set in stone and may be altered by exchange officials to improve liquidity. Strike prices close to the price of the stock or index are called "near the money" or "at the money." Strike prices with little chance to close "at the money" are called "out of the money" and have much more risk.

The most important point to remember is that the options closest to the money trade the most often and generally have the lower risk. That said, they also have the highest price. Experienced traders like to trade options within a few point of the money and with 30 to 90 days expiry dates. The time premium is lower and the profit potential and liquidity is higher. The exception might be in preparation for a Y2K-like crash where the out of the money LEAPS might make sense.

Expiry: Options have expiration dates on cycles: Jan/April/July/October or Feb/May/Aug/Nov or Mar/June/Sept/Dec. The longest term options typically expire in 9 months or less, except for LEAPS. Typically the last trading day for an option is the third Friday of the month at the close of trading. You must sell the option or exercise the right to buy the stock. For our purposes you only need to remember that if this is the first week of the month of October, and you buy the October calls or puts, you only have a couple of weeks before your option is worthless. If you buy the January 2001 LEAPS you have plenty of time but you will pay a high premium for time and your asset is wasting away every day you are wrong.

Details of Option Trading: The sooner you sell an option the better. Place a limit order to sell as soon as you buy it. Options trades typically have a one day settlement so the trade settles the next day of business. Most brokers require that you pay in cash. Options are not marginable. Options are open for trading in rotation after the stocks open for trading. There may be volatility in the first hour of trading or a market panic where prices are severely distorted. Here is one time where knowing what the options are worth will save you overpaying by up to 300 percent.

Open Interest and Volume: You can see how many options are currently held by looking down your Options Chain under Open Interest. The Volume column will tell you how many options are currently trading. It helps to keep track of both and check the calls against the puts to see where the buying and selling is. But don't assume the crowd is right. They often are not. You can also find high and low prices for the day and the last trade. Those will give you an idea what to bid and then what sell price you might expect depending on market swings and volatility.

Each series of option has its own symbol. Looking at the Options Chain on www.moneynet.com or www.dingdingding.com, you might see something like OEY Oct9 670 P. That means the symbol for the October 670 Puts on the OEX (which is the ticker symbol for the S&P 100 index), is OEY Oct9 670 P. That means the option is a Put and will expire October 1999. When placing orders you may see an expanded symbol like OEY.VN. Each strike price has its own symbol but you may not need to use that for orders, depending on your broker. And if there is a zero after the month, they expire 2000. A number one after the month would be the January 2001 LEAPS and so on.

Market vs Limit Orders: Market orders will get you the option at the best possible price as soon as the order hits the exchange floor. You could get much less than expected if there is insufficient liquidity or a "fast market." We avoid market orders 95 percent of the time. A limit order will get your order filled at your price or better. Or not at all. If you bid right at the last trade you see on the Options Chain and the market is ticking away from you, you will not get filled. Better to bid a 1/4 point or « point limit higher to increase the odds of getting filled without the risk of overpaying on a market order.

Day Orders vs Good-until-Canceled: If you are actively trading and know your bids you will use day orders which expire that day if not filled. If you are a casual trader buying longer term calls or puts or LEAPS you may want to place bids using Good-until-Canceled orders. Options with longer time premiums don't always trade every day and may take longer to fill and to sell.

How to Begin: You will need to set up an options trading account. Often that means qualifying for a margin account as well. Speak with several on-line brokers and ask about commissions. You will pay more for options trades than for round lot stock trades. And not all brokers can trade XAU options on Philadelphia, so ask around if you plan to trade the mining company index for a bull market in the metals. If you want to day trade, you need to watch the ticker for market direction. You can find that on the internet or by watching CNBC. You may also want to get a real time data service, at least Nasdaq level 1, with a service like DTN. We invest over $4,000 per month on data services and research, including commissions.

Start trading with a few thousand dollars. Commissions will consume too much if you trade with less. You may want to "paper trade" while you are waiting. But just because you see a price on the screen doesn't mean you could have bought it or sold it for that. And the emotional stress isn't there with paper trading. It is a big difference once it is your money involved. You will soon learn what your comfort level is, how much you can invest at one time.

Most of all, have fun. This will likely be the most challenging and exciting activity you do. Don't use money you can't afford to lose. Consider it an education. Hopefully you will learn how to trade options successfully without spending a year's worth of tuition to a good business school.

The purity of gold is measured in carat weight.

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