From the May 01, 2011 issue of Futures Magazine • Subscribe!

Options trading: 10 key principles

Investors can use options to get income from non-dividend-paying stocks or to purchase a stock and limit its risk. Traders can use options to add leverage with an acceptable level of risk that is truly limited, as well as to trade up, down and range-bound markets.

Despite these benefits and continuously growing volume (more than 15% compound volume growth since 1973), options are still in their infancy regarding public understanding and acceptance.

Here are 10 key principles that newcomers to options should keep in mind as they approach the options arena. While the potential list of principles is considerably longer, a good number to start with is 10.

1. Know the difference between using options to invest and using options to trade: Investors focus on the benefits of long-term stock ownership, and they should use options to buy, sell, or protect stock positions, or to increase income from stock positions. Consider an investor planning to buy stock when he receives a year-end bonus. This investor can buy one call today for each 100 shares he plans to purchase. A call option is a contract that gives the buyer the right to buy the underlying stock at the strike price at any time until the expiration date. Essentially, for paying the cost of a call plus commissions today, the investor locks in a purchase price for the stock equal to the strike price of the call for the life of the contract (see "Keeping it simple"). If the stock price is higher when the investor receives the bonus, then he still can purchase the planned-for number of shares. Without the call, the number of shares would have to be reduced given the higher stock price.

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The covered call is another common investment-oriented option strategy that enables investors to get income from non-dividend-paying stocks. In this strategy, calls are sold on a share-for-share basis against purchased or owned stock. The seller of a call, in return for the premium, assumes the obligation to deliver the stock at the strike price if the call buyer exercises the right.

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