Options for Rookies 2013

The 2nd edition of The Rookie’s Guide to Options has been published and is available at amazon.com.

Revised and expanded with even more detailed discussion.
Two new chapters: an introductory discussion on calendar spreads, and traps to avoid when exercising options.

Your father’s stock market

There was a time when diligent individual investors could hope to do research, perhaps visit company retail outlets (if they had any), or places where the company did business, and make an intelligent decision as to which companies were worthy of their investment dollars. If the company prospered and earnings and revenue increased every year, then the stock market rewarded investors with a higher price/earnings ratio and a significantly higher stock price. This process required years to bear fruit.

Our stock market

In today’s world, business leaders (the CEO) are rewarded for making the stock price move higher this quarter and this year. There is little emphasis on growth. Thus, there is far less incentive for us, the individual investor, to buy stock with the intention of holding for growth over the years. And it’s not only the CEOs who drive this need for instant gratification. Trader holding periods are getting shorter. Day-trading is popular. So is momentum trading (the idea of following the ‘hot’ stocks). This may not kill the idea of ‘buy and hold’ but other ideas seem to be more attractive for investors.

Add to that mix the idea that computer algorithms are increasing their share of the trading volume, and my conclusion is that much of the prices we see in the stock market come from factors that have nothing to do with the quality or long-term prospects of the company.

For all those reasons and more, using options to hedge investment risk makes sense. Why depend on the stock to grow well over the years when you can (for example) write a covered call instead of simply owning stock. This increases your chances of earning an acceptable profit, and far more quickly. If you want to avoid being at the mercy of traders and computers who drive prices higher and lower; if you are a non-greedy bullish trader who wants to increase the chances of making money – just in case the markets stop rising and begin to trade in a range; then writing at-the-money (ATM) calls offers an excellent opportunity to earn investment returns that exceed the needs of most traders.

What can go wrong? We must remember that writing a covered call is only a little less risky than owning stock and that a downside market can prove costly. However, if your plan is to hold that stock anyway, then writing covered calls does not involve any extra downside risk. We must also remember that this strategy places a cap on possible profits. However, unless your expectation is for the stock to make a dramatic move higher, the available profit (the premium collected from writing the ATM call) should look quite attractive, especially when considering the time required to earn that profit.

If you accept the premise (and not everyone does) that investing has changed and that there are too many unpredictable variables that affect the price of your investment, then collecting steady premium by selling covered calls is an alternative strategy worthy of your consideration. However, it does require a neutral to bullish outlook for the stock market.

This post was originally published by TradeKing.