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The right way to use stock options
Here's a strategy for locking in gains and lifting overall returns.
August 18, 2004: 10:09 AM EDT

NEW YORK (CNN/Money) - Buying stock options is a game for saps. Since the market for publicly traded stock options developed 30 years ago, many individual investors have tried playing the options market in the hope of making a killing. But just as in a casino, the options market is biased in favor of the house -- and against you.

The value of an option depends on how long it has until expiration and the volatility of the stock it's tied to.

A 17-part series on how to achieve maximum returns for the right amount of risk. See all the lessons.

Call options (giving the holder the right to buy at a set price by a set time) profit point for point when a stock goes above the option's strike price. So the more a stock swings and the more time you have until expiration, the greater the chance it will move in your favor.

Put options work the same way, but in reverse. Their value rises when a stock goes down.

The big attraction of options is that your possible profits are unlimited, while the most you can lose is the cost of the option. But there's a catch: Based on volatility and the time remaining before expiration, it's possible to figure out mathematically what options are really worth -- and they're usually overpriced. That means that option sellers generally end up winners over the long term, and buyers end up losers.

There's only one way to shift the odds in your favor -- become a seller rather than a buyer. That's dangerous if you sell options on a stock you don't own, because your potential losses are virtually unlimited. But it's a winning strategy if you use options to increase profits on a stock you do own.

Say you buy a growth stock on a dip, and two months later, it's up 20 percent, from $25 to $30. If you sell the stock at that point, you won't have much profit left after commissions and taxes. But by selling a call option on that stock, you can protect your 20 percent profit and still have a shot at even bigger gains.

With the stock at $30, you might be able to sell a $30 call for $3.50. That $3.50 is yours no matter what. If the share price keeps rising, when the option expires the stock will be called away from you at $30, so your effective sell price will be $33.50 ($30 plus the $3.50 you sold the call for). That boosts your capital gain to 34 percent.

If the share price goes down, on the other hand, the option will expire worthless -- but you'll get to keep the $3.50. Either way, you're better off.  Top of page




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