by Nancy Zambell, Contributing Editor

Last week's issue of Financially Fit introduced options, defining the terms commonly used among options traders. This week, we'll delve a little deeper into the subject by discussing options pricing, and then looking at a few options strategies that you may want to consider.

First of all, anyone interested in trading options needs to be familiar with how options are priced and why the premium changes.

The option price, or premium, consists of two primary elements:

Intrinsic Value is simply whether the option is in the money or out of the money, terms I defined in last week's issue. Intrinsic value is the relationship between the option's exercise or strike price and the current price of the underlying security. Generally, an option that you can make money on now (in the money) will have a higher premium than one that is currently out of the money.

Time value is the amount of money that you are willing to pay for the option over and above the intrinsic value, prior to its expiration date. You might pay this if you thought the value of the option would increase because of a favorable change in the price of the underlying security. Generally, the longer the time period before the expiration date, the greater the time value (as you have more time for the price of the shares to increase or decrease, depending on the type of option you purchased).

Additionally, there are two more factors that influence the premium:

• Volatility of the underlying security. Difficult to quantify, but very often significant. The volatility, or uncertainty in the price of the underlying security, will make the option premium rise, as investors who expect fluctuations in the share price demand to be paid for that risk or uncertainty.
  

• Dividends and risk-free interest rate. Not generally a major influence on premium prices, but this "cost of carry" is an opportunity cost, or a return that you may be passing up by not investing in alternative investments like Treasury Bills or dividend-paying stocks.
  

Now, let's talk some options strategies. Last week, in my "in the money" definition, I gave you an example of buying a call option, the right to purchase 100 shares of a stock - an option you would purchase if you were bullish on the underlying stock.

Next, let's look at buying a put option, the right to sell 100 shares of a stock - an option you would purchase if you were bearish on the underlying stock. Here's how it works:

Let's take last week's call option example and reverse it. Now you buy a Jul 20 put option, for $5, so you pay a premium of $500 ($5 x 100 shares). If the shares fall below $20 by the third Friday of July (the option's expiration date), you are "in the money" and if you are far enough in the money to recover your initial $500 outlay + some, you would want to exercise your option.

Let's say the shares have fallen to $10. You then buy them for $1,000 ($10 x 100), then sell them for $2,000 ($20 x 100), deduct your initial $500 outlay, and your profit is: $500, or $2,000 - $1,000 - $500 = $500 = Your Profit

Buying calls and puts is the most popular of option strategies and can bring substantial profits, even to novice options traders. But there are scores of additional options strategies being utilized daily in the markets - many of which are extremely complex and should be plied by only the most experienced of traders. Consequently, I'll leave their exploration up to you, but caution you not to try for the home runs before you learn the basics through trial and error - and preferably, profitable experiments.

However, there is one more options strategy that has caught on with the masses that I want to tell you about. It's called covered call writing.

In a covered call, you sell the right to buy stock that you already own. For example, you purchase 100 shares of stock for $15 a share. Right away, you write a covered call option at a strike price of $20, for a premium of $2. You immediately earn $200 ($2 x 100).

If the shares don't go above $20 before the expiration date, the option buyer doesn't exercise his option, and you have netted a cool $200. Of course, if the share price declines below the initial $15 you paid, you are sitting with a loss, if you continue to hold them.

However, if the share price zooms up to $30, your option buyer is going to exercise his right to buy them, and he - instead of you - is going to reap the reward of that $10 per share climb (minus the $200 he paid to you for the option). This would be your downside, or opportunity cost. But you've still earned the $200 premium, so you can't cry too much.

Covered call writing has become very popular, but it is not the risk-free strategy that many advisors often tout. Remember, you own the shares, so you are still subject to the risk of those shares declining below your original purchase price.

I hope that you now feel a little more comfortable with options and can at least see their potential for adding a little "oomph" to your portfolios. I encourage you to learn more and would recommend that you visit these websites to further your education:

Chicago Board of Exchange (CBOE):

http://www.cboe.com/LearnCenter/Tutorials.aspx

NASDAQ:

http://www.nasdaq.com/options/education_area.stm

Yahoo:

http://biz.yahoo.com/opt/education.html

Have a great week, and happy investing!

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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