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

Options trading: 10 key principles

Consider XYZ stock trading at $53 on May 15 and not paying a dividend. XYZ has a 60-strike call option that is trading at $1.10 and expires in 90 days at August option expiration. An investor might create a covered call by purchasing 300 shares of XYZ stock at $53 per share and simultaneously selling 3 XYZ August 60 calls for $1.10 per share. If the price of XYZ is below $60 at expiration, then the calls expire worthless and the premium of $1.10 is kept as income (see "Covering your bets," below). In this case, $1.10 is approximately 2% of $53. That equates to 8% per year, not including commissions, if a similar-priced call could be sold every 90 days, which might not be possible. Regarding the obligation, if the price of XYZ stock is above $60 at August expiration, then the buyer will exercise the call, and XYZ must be sold at $60. In this case, the gain of $7 from $53 to $60, plus the 1.10 premium, totals $8.10 or approximately 15% of the $53 purchase price. This is an excellent profit in 90 days, but it is possible that simply holding the stock would be more profitable.

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Traders, in contrast to investors, are short-term market timers with little interest in owning the underlying stock, and they often use a high degree of leverage. Purchased options give traders the potential for considerable leverage with limited risk, the so-called "home run." But the risk is real. Options can lose 50% or more of their purchase price in a short time if the price of the underlying stock moves the wrong way. Also, out-of-the-money options expire worthless at expiration for a total loss of the price paid, plus commissions.

2. Investors who use options need a plan: Will a purchased option be exercised or sold if it is in-the-money at expiration? Covered writers must know whether or not they are willing to sell the underlying stock. If not, it is best to decide in advance at what price the call will be repurchased or rolled to
another option.

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