Sept 11, 2002

Introduction

Not only have investors lost a great deal of money in the stock market in recent years, a new poll tells us they lack confidence in their ability to make money in today's stock market. An NBC news poll, taken in conjunction with a recent TV special (NBC News Dateline, July 27, 2002, "Take the Money and Run"), shows that

• 11% are very confident of their ability to make money in the market
• 28% are somewhat confident they can make money in the market
• 59% are not confident they can make money in the market

In addition to their lack of confidence, many investors are afraid of the market. Many are afraid to maintain their holdings for fear they will lose even more of their savings. Others are afraid to sell for fear the market is approaching a bottom.

There is no cure for the anxieties of these investors, but there is a conservative strategy that many could adopt to ease their concerns. This strategy

• Increases their chances of earning a profit in the coming months
• Makes their portfolios safer
• Losses are less likely to occur
• If losses do occur, they are smaller

This strategy involves the use of call options. Many investors run when they hear the word "options" because they have not learned how options can be used intelligently and conservatively to reduce the risk of their stock market investments. Despite the fact that better-educated investors trade with more confidence and make more money, investors have not educated themselves to the opportunities available from the use of stock options. This column continues (see Basic Concepts) your education with a simple example of how call options can be used to provide the benefits outlined above.

Message to Investors

If you are considering investing money in today's market, this strategy reduces the risk your new investment will lose money. Not only do you gain some protection against falling prices, but this strategy increases the chances you will earn a profit.

If you are already invested and are considering selling part of your portfolio to reduce the risk of further losses, this strategy allows you to maintain your holdings and reduce your risk.

Example of the strategy

You already own, or want to buy 100 shares of Microsoft. (Caveat: This stock was chosen for illustrative purposes. This is NOT a recommendation to buy this stock)

• Assume MSFT is trading for 48.25 per share
• Either buy 100 shares
• Or use 100 share you already own

Sell to someone else the right to buy 100 shares of your MSFT stock at a price of $50 per share. This right is called a call option.

• The right to buy your stock expires in 6 months
• For that option, you receive $550 in cash, or 5.50 points per share of stock
• You keep the cash, no matter what else happens
• If the other party wants to buy your MSFT stock at any time during the next 6 months
• You are obligated to sell the stock for $5,000 ($50 per share), regardless of the market price at that time
• Your total selling price is 50 from the stock sale, plus the 5.50 from the option sale, for a total of 55.50 per share

What happens next?

If the stock pays a dividend (MSFT pays no dividend) while you still own it, you receive the dividend.

At the end of 6 months, two different outcomes are possible:

• The other party wants your stock.
• You sell the stock for $50 per share
• You can add the $550 cash ($5.50 per share) you received to the sale price
• Your total sale price is $55.50 per share.
Since the stock was bought (or was worth) 48.25 when this deal began, you have a profit of $725 on your investment.


• The other party declines to buy your stock
• You no longer have any obligation to sell the stock, as the option has expired
• The $550 cash you received can be used to reduce the cost of your investment. The stock cost $4825 originally; the adjusted price is now $4275
• If the stock has declined in price since you made this deal, it is worth less than when you sold the call option,
• But, if the stock declined by less than 5.50 points, you actually have a profit (you made more from selling the call than you lost from owning the stock) - even though you own a stock that has declined in price.
• If your stock is lower than 42.75, you have a loss - but that loss if $550 less than it would have been if you did not sell the call option.

This was a satisfactory deal for you. If the other party wants your stock, you have a profit of $725. If the stock declines in price, you may still show a profit. (This is the reason selling the call option makes it more likely you will earn a profit from the transaction.) If you have a loss, the loss is $550 less than it would have been without selling the option. If all outcomes are good, then, we must ask:

What can go wrong?


• Your maximum profit is $725. If the stock undergoes a large rally, you have to settle for a smaller profit than you would have made without the sale of the option. No matter how high the stock goes, you maximum selling price is 50 (plus the 5.50 from the call sale).
• If the stock undergoes a substantial price decline, you will have a loss. However, the loss is $550 less than it would have been without the sale of the option.

Summary



In this simple example, you sold a call option and increased the chances you will have a profit at the time the option expires. You also gained insurance against a decline in the price of your stock. There is much more to learn about options, so if this whets your appetite for more, explore more of this web site, or read our book.

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To learn about our book, click here .


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