Understanding Basic Option Strategy

• 1). Know that option trading strategies are designed to capture the time value of money, capture the direction of an individual stock, hedge risk, or combine with other options to create a synthetic trading security. Option trading begins with the thesis that there is an implied cost to using funds in any investment horizon. Therefore, the efficient solution is to reduce risk by investing as few dollars as possible to gain the same relative performance.
  
  
• 2). Trade an option like a stock. The LEAP option series can extend almost three years. LEAP is Long Term Equity Appreciation Security. LEAPs can be written out to three years as either a call ( bullish direction for the stock) or a put (bearish expectation) for most NYSE stocks. One popular strategy is a covered call where a stock is purchased at say, 50 and a LEAP call is sold giving the call buyer the right to buy the underlying stock at an agreed upon price, called the strike price, at 60. The call option is worth 5 points because it is a claim on a stock worth 50. The option writer keeps the premium and any dividends the stock pays. The investor receives an above average return for a stock because the call buyer doesn't want to risk the 50 necessary to buy the stock. He spends 5, using the option as a proxy for the stock movement. Both parties achieve their investing objectives.
  
  
• 3). Hedge a portfolio. This is an important trading activity. A portfolio with large capital gains can be protected against down markets by selling index options similar in credit to the portfolio. Selling the portfolio would unleash large capital gains. Selling call options would only result in a loss to the portfolio if the market did not decline and the options expired worthless. A continued rise in the portfolio value and the dividends of the portfolio allow the options to expire but still provide a lower risk adjusted return to the portfolio.
  
  
• 4). Exchange volatility for diversification. In addition to your regular stock holdings, buy options on major indexes to take advantage of broad moves in the marketplace. The combined effect is to substantially reduce volatility because the small options holding will move with the broad market. Having representation in the broad index creates a higher level of diversification.
  
  
• 5). Buy favorite stocks at cheaper prices than the current market. Sell a put for 2 points on a 40 dollar stock. If you like the stock credit the current price of 40 minus the value of the put you sold. The put buyer has the right to sell you the stock at 40 or below by the expiration date. This gives you a cost of 38 if at the end of the option the price is below 40. The stock may rise in value, but the premium is yours to keep without the stock. Anticipate another market move and earn more premium as long as the stock is fairly valued by you.