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An option is a financial derivative.  Please do not let the wording dissuade you from learning about options, they may be the most important part of your investment portfolio.

There are two kinds of Options, a CALL and a PUT. 

A CALL is a contract between parties.  The owner, or buyer of the CALL has a right, but not an obligation, to BUY something, at a specified price and at a specified time in the future, from the seller, or writer of the CALL.  The seller, or writer, of the CALL has an obligation to sell that something, at the specified price, at the specified time, to the owner of the CALL.

A PUT is a contract between parties.  The owner, or buyer of the PUT has a right, but not an obligation, to SELL something, at a specified price, at a specified time in the future, to the seller, or writer of the PUT.  The seller, or writer, of the PUT has an obligation to buy something, at the specified price, at the specified time, from the owner of the PUT.

If you drive a car, you already use options.  By law, you are required to carry insurance.  Insurance is a PUT option on your car.  You pay a premium, your insurance payment, and your insurance company will fix or replace (buy) your car if you get in an accident.  You do not have to use your option, if you do not get into an accident.  Your premium covers you for a set amount of time, a month, a quarter, 6 months or a year.  The insurance company is the seller (writer) of the PUT and you are the buyer. 

I have simplified this example.  To be continued….

Diagonal Spread Example:

Sell GGBBU            Feb 2009    7.5 Call            $0.35

Buy KDMAZ            Jan 2010   2.5 Call             $4.40

 

Net Cost                      $4.05(+Trading Costs)

 

Maximum Loss            $4.05(+Trading Costs)

 

GGB is trading for        $6.54 at the close on Tuesday 01/27/09

 

If GGB trades above $7.50 on February 21, 2009 the gain will be $0.95(Less Trading Costs).  Lets assume $0.50/share trading costs, the return would be approximately 11% for 25 days.  Not Bad, but this is not what I am looking for.

 

If GGB does not go above $7.50, AND

 

If GGB trades at $6.54 on January 16, 2010 the loss would be $0.01(+Trading Costs), however this assumes that you do not sell more call options during the year.

 

If GGB trades much lower, this is the worst case scenario, however GGB is trading near its lows for the past year.  The Maximum Loss is $4.05(+Trading Costs) no matter what happens to GGB.

 

If GBB trades much higher, the return will depend if there are any outstanding options that have been sold.  At some point, if GGB trades much higher and you still own the $2.5 options, we can protect some gains by buying puts.  Let’s see where it moves.

Prices are determined by the market. There is a financial theory called the Efficient Market Theory. According to this theory, all public information is immediately priced into the market. If a drug company is getting approval from the FDA for a drug, then the market will adjust “immediately”. If a company loses a court case that will cost millions, the market adjusts “immediately”. Mainly, investors that want to buy a stock have a price, above which, they will not buy the stock, and investors that want to sell a stock, below which, they will not sell the stock. Most of the time these prices get worked out as a bid/ask price.

There are many different ways to measure the value of a company. These ways currently fall into two main categories. They are Fundamental Analysis or Technical Analysis.

Fundamental Analysis uses the information about the company, the market, the economy and the competition. One of the main starting points in this analysis is the Capital Asset Pricing Model (CAPM). This model estimates future earnings, based on current earnings and growth rates and the discounts these earnings into todays dollars. Key assumptions that need to be made, that can affect the validity of the calculation, are growth rates, interest rates, inflation rates, future costs, etc.

Technical Analysis uses market information to predict future price moves. Practitioners of this analysis are sometimes called chartists. They do not care about the specific company. They look for specific patterns in the trading data (price movements, volume, etc.) that gives them an indication of the future direction of the price of the stock.

An Exchange Traded Fund (ETF) is a Mutual Fund whose shares trade on an exchange, such as the New York Stock Exchange (NYSE). These shares trade every day, all day that the exchanges are open, just like a stock. Normal Mutual funds only trade once a day, at the end of the day, at a set price the NAV or Net Asset Value. The NAV is determined by the price of the stocks or bonds that the fund owns multiplied by the number of shares that the fund owns divided by the total number of fund shares. ETF’s are priced by the market. In theory, the price of the ETF should be the value of the shares that the ETF owns. However, in practice, the price can vary, thereby producing a premium or a discount. A premium occurs when the investor could purchase the same companies for less than buying the ETF, and a discount occurs when the investor can buy the ETF for less than the price of the shares.

ETF’s can be much more tax efficient than a normal mutual fund, for the individual investor. The investor gets to determine when she sells the shares and realizes gains or losses.

ETF’s usually carry much smaller fees than normal mutual funds. This will result in a larger gain in the long run for investors in ETF’s. If one were to invest in two mutual funds that represent the S&P 500, one a normal mutual fund with management fees of 1% and on an ETF with fees of 0.5%, the ETF will out perform the normal mutual fund by 0.5% per year. This adds up over time.

Cons: Trading costs, commissions are charged by your broker every time you make a purchase or sale. The individual investor needs to be aware of this.

In my opinion, ETF’s are the way to invest for the individual investor. At this time only a few ETF’s are actively managed. This means that almost all ETF’s are passive investments, and the individual investor needs to only pick a benchmark that he wants and then pick an ETF. Verify that the fees charged by the ETF are comparable to al the other ETF’s that match that benchmark.

 Vertical Spread Example: 

 

Sell SRSGK            July 2009    55 Call             $22.00

Buy SRSGI            July 2009    45 Call             $25.50

 

Net Cost                      $3.50(+Trading Costs)

 

Maximum Loss            $3.50(+Trading Costs)

 

Maximum Gain            $6.50(-Trading Costs)  (=$10.00-$3.50)

 

SRS is trading for        $59.44 at the close on Friday 01/16/09

 

Or

 

 

Sell SRSGK            July 2009    55 Call             $22.00

Buy SAKGG            July 2009    35 Call             $29.80

 

Net Cost                      $7.80(+Trading Costs)

 

Maximum Loss            $7.80(+Trading Costs)

 

Maximum Gain            $12.20(-Trading Costs)  (=$20.00-$7.80)

 

SRS is trading for        $59.44 at the close on Friday 01/16/09

 

SRS is the Proshares Ultra Short Real Estate ETF.  This fund moves double opposite the Real Estate ETF.  If the Real Estate ETF move Down 10% The Ultra Short Real Estate ETF will move (approximately) UP 20%.