From The Desk Of: Peter Zomaya, Options Expert & Instructor 11/1/10

As an active trader for over 15 years, Ive seen it all Ive seen fortunes rise from measly, underfunded trading accounts. Ive seen major players tumble, losing it all in a blink of an eye. And heres my major takeaway, all boiled down to just 14 words: Smart Investors Use Options To Leverage Their Capital To Maximize Gains And Minimize Risk. There. Glad I got that off my chest... In just a moment, Ill explain why thousands are abandoning mainstream investments, such as stocks, and flocking towards options as a primary investment vehicle. A quick note: Im not a writer, per se, or a marketer by any means. So I assure you that what Im about to show you isnt hype. But stay with me for just a few moments, and Ill show you the innerworkings of a simple (and often highly profitable) investment tool-Options. But First, A Bit Of History There is a grossly incorrect rumor circulating... As an options instructor, I hear often that trading options is risky business. Now, theres risk in any investment you make, ever. You know that, or you wouldnt be smart enough to be reading this. But options were designed specifically to help hedge against risk. Let me explain. You have car insurance, right? Well, do you consider car insurance to be risky? Of course not. Driving without insurance is risky. The insurance policy is there for your protection.

Options work in the same way. Options provide you with protection and a way to make a return on your investment no matter which way the market goes Waitdid you catch what I just said? Options allow you to make money in a directional manner (either up or down or even sideways). Because of this, professional investors have been using options to their advantage for decades. How To Stack Risk In Your Favor With options, you can reduce risk on speculative moves in the market vs. owning the stock outright. As mentioned earlier, thousands of stock traders are making the switch over to options trading as either a compliment to their stock trading or a complete switch from stock trading. After the options light goes on for many people I often hear them exclaim, Why would I ever trade stocks again?? And theyre right Let me show you a few examples This first example is on Google back on October 14, 2010, one day prior to options expiration. Options are contracts that expire on the third Friday of the month. Google (GOOG) routinely reports earnings after the market close on the Thursday prior to options expiration Friday. (I think they do this just to mess with people, but that is another story for another time) When the market closed on this particular Thursday, the stock was at $540.93. Lets suppose you owned 100 shares of Google. This means you had $54,093.00 tied up in the trade. Many analysts were bullish on Google. Some analysts had price targets of $700 and $800. Everything was looking good going into the earnings report. After the market close Thursday, Google reported earnings that beat all expectations. And on Friday, Google gapped up and closed at $601.45!

As a shareholder of Google, you should be ecstatic. You made an additional $60.52 per share, or 11%. Nice job, take the family out for a steak dinner

Now, let me compare what you could have done by trading the options on this stock. Instead of trading the stock you could have bought the $540 call option on Google. This would have given you the right to buy the stock at $540. The Google October $540 call that was expiring on that Friday after earnings was trading at $12.30 per share. To equal the 100 shares of stock in the last example we would need to buy 1 option contract (option contracts control 100 shares). So our total cost would have been $1,230.00. This total cost, incidentally, would be our total risk. Not the case if you owned the stock

With GOOGLE stock making the same exact move, in the exact same time frame, the $540 call would have been worth $61.45 per share. This is the real value of the option. With the stock at $601.45, (and with you having the ability to buy the stock at $540), the difference between the two would be the real value of that option. As a result, the total value of the option would have been $6,145.00. That is not the profit. To figure that out, we would need to subtract the initial debit we paid for the option or $1,230.00 for a $4,915.00 of profit. On the surface this doesnt look as good as the stock position. The stock trade yielded us a profit of $6,052.00. So our profit was lower. But if you look at the capitol tied up in the stock trade ($54,093.00) the numbers are now much better. The option trade yielded $4,915.00 of profit on a $1,230.00 investment, or a 399.6% profit. Now, you dont need to be a rocket scientist to do that math. I just showed you a huge return on a relatively small investment. Thats the power of leverage. Large returns on less capital. If you know anything about trading, you know that this is a good thing Nothing feels better than bankrolling 400% profits on your investment. But what about this scenario What would have happened had Google stock fallen that same amount (or more) if the earnings were a disappointment? If the stock fell $60, the stock position would have lost $6,000.00. Not good. But with the option position, you could have only lost $1,230.00 or about 20% of the loss that the stock trader incurred. See the power? High returns, much less risk. Here is another example on a company called Potash (POT). Lets say you were bullish on POT. The date is August 12, 2010. You see from the chart that POT has sold off for the prior couple days, then had a good up day, which was a bullish indication for you. So you go out and buy 100 shares of the stock.

August 12th, the stock closed at $112.04. So now you have $11,204.00 tied up in youre the ownership of POT. August 17th comes and there is a takeover bid for POT by a company called BHP Billiton. The price skyrockets up to $143.17. Your stock just jumped up $31.13 per share from your purchase price giving you a total profit of $3,113.00 on your 100 shares. Youre happy as can be with your investment. How can you be unhappy?? You just made nearly 28% of profit in just one week.

Lets see what would have happened if we would have traded options instead. Since the initial date was August 12th, that is fairly close to the August expiration. We would want to give ourselves more time in the options than that, for a chance to be right.

For this example we will use the September options. With the stock at $112, the next option listed would be the 115 call for September. The 115 call would give us the right to buy the stock at $115. On August 12th, the 115 call was trading for $4.20 per share. To equal our 100 shares of stock we would require the 1 contract for a total cost of $420.00. When the stock jumped up to $143.17 on the 17th of August, the September 115 call was trading for $28.35 per share. Now you might ask, why is it trading for more than the real value of $28.17 (the difference between the $143.17 stock price and the 115 call we own)? The answer is something called time value, something we options traders call theta. Since there was more time left in the option, prior to the September expiration, that time value was part of the option price. If we look at the profit of $2,415.00 (115 call value of $28.35, minus the $4.20 we originally paid equaling $24.15 per share) that gives us less dollar profit than we made with the stock ($3,113.00 profit), but the percentage of profit was 575% on the option vs. the 28% of profit on the stock investment. The larger benefit is that we only had $420.00 of risk on the option vs. the $11,204.00 of risk on the stock. Less risk than stock, higher returns. Thats awesome. If you wanted to make a larger profit, you could have traded two contracts, risked $840, and made $4,830.00 of profit. The percentages are identical; you are just increasing your leverage. Let me show you one more example, where you can use options along with stock as a protective measure. Here is an example on CREE. CREE is a company that produces LED lights. It seems that everything has LED lights. All the new televisions, brake lights on your cars, flash lights, the traffic lights at intersectionspretty much everything. Lets say you owned CREE going into the earnings announcement on August 10, 2010 when the stock was sitting near $69.00 per share and lets say you owned 100 shares. You were bullish on the stock (the only reason for owning stock). So you have $6,900.00 tied up in the stock.

CREE comes out with its earnings and the next day the stock goes from about $69.00 down to $59.81 at the close of business. By owning the stock you would have lost $9.19 per share. That would equate to $919.00 for the 100 shares or a 13.3% loss on the stock. OUCH! The stock also continued down from that point to below $50.00. For this example we will only look at the one-day drop and not the complete $20+ drop the stock has sustained.

What could have been done to protect that stock from a downfall? You could have purchased a put option, basically an insurance policy. The day before the earnings announcement you could have bought a 70 put for the August expiration. Since you were protecting yourself from a drop due to earnings, you could have used a shorter time frame for the options. The August 70 puts were trading for $3.90 per share or $390 per contract.

The next day when the stock dropped to $59.81, you would have sustained the same loss in the stock as owning the stock alone. The difference comes from owning the put (insurance) on the stock. The 70 put you purchased for $3.90 the day prior became worth $10.15 when the stock dropped. You lost $9.19 on the stock per share, but you made $6.25 per share on the put option you owned. Your loss was only $2.94 per share or $294.00 for the 100 shares. As you can see, you hedged your loss by a huge margin. If you looked at the continued loss on the stock dropping down below $50 the numbers would have been a staggering loss on the stock, but due to your protective option in play, you experienced a relatively insignificant loss of your investment capital. If youre an investor, I truly hope you see how powerful options can be as a tool to manage risk and leverage your investment capital for maximum gains. As you can see by these brief examples, options are a great investment vehicle for investors of all types. Many options strategies can profit 3 ways if a stock goes up/down, stays the same, or only goes down/up a little. Stocks only make money if they go up (unless youre shortwhich is potentially very dangerous). Options allow you to control large amounts of stock for a fraction of the price of owning them outright leverage and they limit your risk, something you need to be doing in todays volatile market. Over the next few days, Options University will be releasing more options education in preparation of a new options trading program that can get you up to speed and trading options successfully in no time, flat. Youll soon be one of the millions of former stock traders saying, Why would I ever trade stocks again? Stay tuned and trade safe.

Peter Zomaya Options University www.optionsuniversity.com