TESTIMONIALS . . .
Mike – There is not a day that goes by that we do not think of you and are thankful for the introduction to this world of non directional trading. I urge all traders to take your course and then begin to think and trade for themselves – and use the creative license you allowed us to receive. – Ron
Mike – You should be very proud of your performance, and I just wanted to thank you for teaching me your strategies. – Lee
Mike – I fully value and appreciate your candor, strategies and insight. You simplify what others try to complicate. I have gleaned a wealth (full pun intended) of information from both your newsletter and class. – Gene
And Then There Were Options . . .
By Mike Parnos
The word “options” often sends a chill up and down the spines of traders everywhere. These naïve traders have heard dozens of horror stories about people losing their life savings trading options. The word “options” generates fear. Hence, there is a huge stigma attached to the word “options.”
Are the horror stories true? Is it true that people have lost fortunes trading options? Of course it is. Does this still happen today? Of course it does. Will it happen again in the future? Of course it will. Why? There is one common denominator shared by those who have lost (and will continue to lose) substantial amounts trading “options.” They were S-T-U-P-I-D.
A rather brazen statement, you say? Possibly. But that doesn’t make it any less true. These “traders,” (and I use the term lightly) simply don’t know what they are doing. They’re playing a game in which they don’t know the rules and/or the strategies.
So, call your friends and tell them about this column. Because here is where you, and they, will learn about options. This is a no-holds-barred approach to teaching you about an incredible trading resource. What you will learn here will challenge you. What I say may anger you or make you laugh. But, you can be sure of one thing. If you have the perseverance to stick with me through the coming weeks, you will emerge with the knowledge that can turn you into a consistently profitable options trader. This is not rocket science. You and your friends have the first option – read my columns or lose money.
What Is An Option?
We have to start somewhere. The beginning is as good a place as any. An “option” is nothing more than a tool. If you know how to use it properly, you will likely make money. If you don’t, you can seriously hurt yourself.
There are two kinds of options – calls and puts. First we will address the call option. It’s probably best to provide you with a real life example to introduce you to the concept.
Once upon a time, Max wanted to buy a house for $100,000, but at that moment he only had $5,000. Max anticipated having the balance in three months. But, he was concerned that the price of $100,000 might go up in that period.
Here’s what he did. Max approached the owner of the house and said, “I’ll give you $5,000 right now to take your house off the market. And I want the right to buy your house for $100,000 in three months.” The owner agreed. He figured that he was going to get an extra $5,000.
Max has effectively purchased a “call” option on the house. Max has paid $5,000 for the right, but not the obligation, to buy the house at a specific point in time (three months) for a specific price ($100,000). So, for three months, Max’s $5,000 is allowing him to control a $100,000 asset. That’s excellent leverage and that’s what many market option traders try to use to their advantage.
Back to Max.
Now, three months is a long time. Many things can happen, both good and bad. Let’s look at a few different scenarios.
1. The house is inspected and Max learns that there is a serious termite problem. Plus, the house next door is sold and Max learns that Michael Jackson plans to open a child care center. What’s worse? It’s a toss-up. But it’s not good news, is it? The value of the house is no longer $100,000. Its value is probably closer to $60,000.
So, what is Max to do? If you were paying attention, you saw that Max owns the “right,” but not the “obligation,” to buy the house. When the three months is up, or even sooner, Max can simply say, “no, thanks. I’ll pass” to the owner. What has Max lost? Only $5,000. That was his entire risk. A loss of $5,000 is a hell-of-a-lot better than a loss of $40,000. Max has preserved his capital and can now continue his search for another real estate opportunity.
2. Max learns that oil was found in the backyard on a neighbor’s property. The value of the house skyrockets to $350,000 – just in the hope that there is also oil on the house on which Max owns the option. Max is a happy camper. He’s looking at two alternatives. The option for which he originally paid $5,000, is now worth $250,000 (the difference between the $100,000 and the current $350,000). He has, in effect, turned $5,000 into $250,000.
Max’s other choice is to go ahead with the purchase, at the agreed upon $100,000, and hold onto the property for a further increase in value if they actually discover oil on his property. Should that happen, the house/property could be worth $1,000,000. What would you do?
Now, for a moment, I’m going to jump a little ahead of ourselves to discuss Max’s two choices. If he simply sells the option, he has $250,000 in his pocket – an incredible profit. If he chooses to buy the property, and pray for oil, isn’t he risking the $250,000 profit? If they don’t discover oil, the value of his newly purchased house is back to $100,000, maybe. That’s a gambler’s mentality – not a successful trader’s mentality – that’s STUPID.
Max bought a “call” option and had some choices – that’s why they call them “options.” Choices are always nice to have. The nicest part is that Max’s risk was defined. The $5,000 was the most Max could possibly lose of he chose not to go through with the house purchase.
Applying Call Options To The Market
Instead of buying a house, suppose you thought that IBM had a good chance of moving up in the next five months. IBM is trading at about $80. You could buy the right (but not the obligation) to buy shares of IBM stock at $80 for $5.00. That’s pretty good leverage — $5 controlling an $80 asset.
All the same concepts apply as in our real estate example. The purchase price of $80 (known as the “strike price”), the specific five month period of time and the premium paid for the option ($5.00).
If IBM goes up in that period of time, great! You guessed right. You’ll make a nice percentage on your $5.00 risk. If IBM goes down, you don’t have to buy the stock and all you lose is the $5.00 cost of the option.
Are you ready to make your first option trade? Hell no!! You’re not even close. Keep your money in your pocket. Don’t jump into the pool until you know how to swim. There’s no rush. The market will be there when you’re ready. How will you know when you’re ready? I’ll tell you, that’s how.
