Most small investors would find trading in the Chicago pits where stock options are bought and sold a strange and mystery-shrouded ritual of hand gestures.
And trading options is generally considered the purview of Wall Street’s pin-striped sophisticates.
But Lewisville, Texas, kindergarten teacher Janet Wilson can explain the intricacies of “covered call options” faster than one of her bright 5-year-olds can recite the ABCs.
“I mentioned stock options to one of the other teachers, and she was like, `Oh, my gosh. You know about that stuff?”‘ Wilson said. “Most people think it’s more complicated than it really is.”
She’s right. So listen up, kids, class is in session.
An option is the right, but not the obligation, to buy or sell a stock for a specified price on or before a specific date.
More specifically, a call option is the right to buy the stock, while a put option is the right to sell the stock. But more on this later.
The popularity of options has soared in recent months as small investors, especially the growing legions of on-line traders, have become more knowledgeable about stock trading in general and options in particular, said Bill Ryan, spokesman for the Chicago Board Options Exchange, where most option contracts are traded.
Also, he said increased market volatility typically translates into more options trading as investors try to protect their holdings or perhaps to profit on the gyrations.
“Active investors who do not avail themselves of the options market might be losing out on some investment opportunities,” Ryan said. “Even small investors can use options to better manage their individual stock portfolios.”
The number of option contracts traded on the Chicago Board in March hit 35.2 million, about 80 percent above the same period of 1999. And records are being set almost daily, according to the board.
Options can be used as speculative plays in the stock market, but small investors probably would be much better served staying with one of the more conservative option strategies, financial experts said. For example, options can be used to increase income from current stock holdings (covered call) or to protect stock holdings from a price decline (protective put).
“In the past there was the misconception that options were risky or dangerous,” Ryan said. “But that flies in the face of why options were invented in the first place: to minimize risk.”
Dallas stockbroker Charles Flournoy, who handles Wilson’s options transactions, said investors who take the time to understand options are usually pleasantly surprised at how easily they can add income to their portfolios without adding much risk.
“Investors really should learn about options, but only a few of my clients do because it’s a rather sophisticated strategy and more than they want to worry about,” said Flournoy of Linsco/Private Ledger.
Here are the basics:
The best place to start is with the most popular transaction: buying a call option.
The buyer of one call option purchases the right to buy 100 shares of XYZ company’s stock, which currently is selling for $48 a share, for a slightly higher price in the future, called the strike price. Option contracts are traded in 100-share increments.
So the buyer of one XYZ “June 50” call option has the right to buy 100 shares of XYZ at $50 a share until the June expiration date. The buyer of this option pays a premium for this right, say, $2 a share, or $200. If the underlying stock price rises to, say, $55 a share, before the expiration date, the buyer will exercise the option and make a profit of $3 a share — $5 on the price rise less the $2 premium — or $300. There is risk in this strategy, however, because the stock price might languish at $50 a share or drop lower. In this case, the option would not be exercised, and the investor would lose the $200 premium.
Despite the risk, some investors like this strategy because they are “controlling” 100 shares of stock with $200 instead of actually buying the stock for $4,800 ($48 a share times 100 shares). The most they can lose is their premium, and yet they can share in all the profit if the stock moves higher.
“You have reduced the amount of money at risk,” said Max Ansbacher, a New York investment adviser and author of three books on options. “You could control a $200-a-share stock for, say, $20 and put the other $180 in the bank.”
Still, Flournoy said he discourages his clients from buying calls because more often than not the stock price doesn’t rise above the strike price, and the premium is lost.
Instead, he likes for his clients to sell the call option, instead of buying it, which is what Wilson prefers.
This is a very conservative strategy with limited risk and a nice way to add some income to a portfolio, he said.
Wilson, who can’t afford to lose any money, supplements her teacher’s salary by selling calls.
Here’s how she does it:
First, the call seller must own the underlying stock.
Wilson met that requirement because she had owned 500 shares of Electronic Data Systems Corp. for years.
In November 1999 when the stock was at $62 a share, she sold five June 65 call contracts and received a premium of $5 a share, or $2,500 ($5 times 500 shares).
By selling the call option and receiving the premium, she is agreeing to sell EDS shares for $65 to the investor who bought the call.
The only downside to her strategy is that if the stock rises above $65 to, say $70 a share, she has to sell the stock and doesn’t get to share in the additional profit.
She gets to keep the premium no matter what happens to the underlying stock price.
“I did this because I needed a little extra money,” Wilson said. “A lot of people think this is risky, but if you have a good stock in your portfolio, why not make some extra money off it?”
Flournoy said he prefers to sell calls on very steady stocks because the risk of the price rising above the strike level is lower.
Still, he said, he always tells options clients that they have to be willing to sell the stock if it rises above the strike price.
“That means they may leave some money on the table,” Flournoy said. “But if they are comfortable with that, then they should check it out.”
