Trade Stock Options Like a Pro
By Carleen Hawn

(Business 2.0) – The mere mention of derivatives can scare even the savviest investor. After all, the securities have been linked with financial chaos ever since 1636, when speculation on Dutch tulip bulbs spawned the world's first major bust. Barings Bank and Long Term Capital Management, too, were laid low by bad bets on derivatives. But the term "derivative" shouldn't, in itself, give anyone the heebie-jeebies; it simply refers to any financial security whose value is derived from the current or future value of a separate entity--like a flower bulb, a unit of currency, or a stock. Thus the derivative itself has no intrinsic value. Instead, statistical modeling and other baffling math are used to estimate its worth.

While derivatives are undoubtedly risky, they can be short-term cash generators for investors with significant stock portfolios. "Derivatives strategies can actually lessen the risk of holding long positions in the stock market," says David Graff of Quiet Light Trading in Chicago, a "market maker" on the Chicago Board of Trade who deals in futures contracts pegged to the Dow Jones industrial average. According to Graff, individuals who want to dabble in futures contracts should consider the stock option, which is an agreement to buy shares of stock at a set price on or before a future date. The contract is sold to an investor, who pays the seller a fee for the right to hold the contract until the exercise date. This fee--which could range from pennies to dollars per contract--will always be somewhere between the bid (buyer's preferred price) and the ask (seller's preferred price) figures currently set by the market. The contract is transferable at any time before the exercise date, so you're never locked in.

Say you own Google shares and think the stock could yet move past its current share price of $291 (as of Aug. 8) but not as far as Google's recent high of $314. Sell a "call option" on your shares with a strike price of, say, $300. This contract happens to be currently trading on the CBOT and comes due Sept. 16, with a bid of $8.50 and an ask of $8.80. You could sell your call option to a would-be Google owner for $8.70. If Google shares hit $300 by Sept. 16, you must sell them to the option holder. If Google shares reach only $299, you keep them--and the $8-per-share appreciation--while collecting an $8.70 option fee. If Google does hit $314 by Sept. 16, you'll have given up $14 a share in upside, but you still made $9 per share, plus the $8.70 option fee.

Or let's say you don't own Google shares, but you'd like to, assuming the price is right. You can sell a "put option" on the stock, giving a buyer the right to sell the shares to you at a price lower than $291. You pick a strike price of $280--again, this contract is trading on the CBOT, with a bid of $4.90 and an ask of $5.20. You could sell your put option for $5. If Google drops below $280, the put holder can sell you the shares at that price. If Google is at or above $280 on Sept. 16, you walk away with the $5 fee. "The worst-case scenario," Graff says, "is that you get to buy stock you want at a price you're comfortable paying." -- C.H.