I am sure you've heard stories about people who have made huge sums of money in the options markets. A friend of mine tells me his boss turned his 401-K into a $1.5 million account from $450,000 this year alone primarily by trading options on S&P 500 futures. There's plenty of money to be made in the options market, but there is even more money to be lost. It's incredibly difficult to make money when you're buying options. However, the upside potential is also tremendous, as it's also the quickest way to turn $450,000 into $1.5 million. Yet as I mentioned last week, options trading is extremely risky because you need to accurately predict several different variables in order to make money (you need to get many more things correct than if you had just purchased the underlying stock).

STRATEGY #1: OUTRIGHT OPTION PURCHASE
The first strategy that I am going to review is the outright purchase of an option. For this example, I'm going to analyze call options on the Nasdaq-100 Trust (QQQ). At 10AM on Thursday, November 6th, QQQ was trading at $35.56. The December 2003 $37.00 calls were bid at $0.60 and offered at $0.70. This means that you are buying the calls with an underlying implied volatility of 25.4% (if you are selling the options, the volatility is 23.1%).

Let's take a look at what would happen to your account under a few different scenarios. For the sake of this example, I'm going to compare the profit or loss between buying 100 shares of QQQ and buying three (3) $37.00 December QQQ calls.

SCENARIO #1A:
QQQ moves immediately to $36.00. Assume that volatility remains unchanged.

Hold 100 shares: Profit of $44.00
Hold three calls: Profit of $15.00 (bid price on option rises to $0.75, offer price rises to $0.85).

SCENARIO #1B:
QQQ moves immediately to $36.00, but volatility increases by 2%.

Hold 100 shares: Profit of $44.00
Hold three calls: Profit of $45.00

SCENARIO #1C:
QQQ moves immediately to $36.00, but volatility falls by 2%.

Hold 100 shares: Profit of $44.00
Hold three calls: Loss of $15.00 (bid/ask moves to $0.65/$0.75, so the option still increases in value, but because you sell at the bid and buy at the ask, you lose money).

Please realize that these numbers are not really directly comparable. As I will show below, your maximum gain is infinite when you buy a call, but your maximum loss is limited to your initial investment. Let's look at a couple other examples.

SCENARIO #2:
QQQ rallies to $38.50 in one month.

SCENARIO #3:
QQQ rallies to $38.50 in one week.

You can see the importance of time value here. If the fund takes a full month to reach $38.50, then there's really not much of a difference in the profitability of the three calls versus holding the underlying stock. However, if QQQ rallies quickly, jumping to $38.50 in just one week, then as you can see in Scenario #3 above, your gains will be far greater if you hold the options. Recall also that you must invest a full $3,556 to purchase 100 shares of QQQ, but you'll only have to spend $210 for the two calls. Therefore, your percentage gain on your money at risk is far greater with the call options!

SCENARIO #4:
QQQ falls to $35.00 in one week.

Should QQQ tumble to $35.00 in a short period of time, then you'll do much worse if you hold the options. Remember, the three calls represent an interest in 300 underlying shares of QQQ. If you had instead bought 300 shares of QQQ, then you'd be down -$168.

SCENARIO #5:
QQQ falls to $32.00 in one week.

In this scenario, your call options have now lost just about all of their value. Still, even though your options control 300 shares, these losses are far smaller than what you'd be showing if you had bought just 100 shares of QQQ itself.

SCENARIO #6:
QQQ rises to $36.75 at the close on December 19, 2003 (option expiration day).

Hold 100 shares:  +$119
Hold three calls:  -$210

In this case, the options will expire worthless. Volatility is meaningless here.

As you can see, making money by purchasing call options (or put options) can be very challenging. While the gains can be enormous, you can very easily lose your full investment. In addition, even if you correctly predict the movement of the underlying stock, you'll still lose money if prices do not move quickly enough. However, on the other side of the coin, your total losses (in terms of a dollar amount, not a percentage value) will be much lower than you would otherwise experience on an extreme adverse move in the stock (assuming that you invest a much smaller amount of money in the options than you would in the underlying stock or ETF).

WHAT ABOUT THOSE PRETTY PAYOFF CHARTS I ALWAYS SEE?
You will not see any here. Why? Because those charts assume that you hold the option position until expiration. Most options that are held to expiration expire worthless. This is why I have presented multiple scenarios with different price changes and position holding times. By presenting return values in this manner, my goal is to give you an idea of how much money is at risk and how time value will affect your holdings.

CAN YOU TELL ME ABOUT SOME OTHER OPTIONS STRATEGIES?
There are many potentially profitable options strategies out there. However, most of them are quite complex, in many cases involving the purchase and/or sale of multiple options at multiple strike prices. Meanwhile, others may also include the purchase or short sale of the underlying stock. I am not going to discuss these strategies because:

• Retail commissions are too high to make these strategies profitable most of the time.
• The bid/ask spread is too large to make money except when the market manages a large move.

Instead of covering these more complex trades, I'm going to define a few more basic strategies and will explain how to construct them and what needs to occur for you to make money.

STRATEGY #2: SELL SHORT (WRITE) NAKED OPTIONS
If you try to do this with a full-service broker, you will probably need to prove that you have an advanced degree in options trading and have been executing these trades for roughly a million years. Of course, the fact that most options expire worthless means that Wall Street is probably just trying to protect the money machine they have by taking the opposite side of all options purchases made by their retail clientele!

Why would you write a naked option position? That's simple. If you write a call, you expect the underlying security to fall in price. If you write a put, you expect the underlying security to rise in value. In both cases, however, you can make money even if the security's price moves against you, especially if you wrote out-of-the-money options. Just look at Scenario #6 above and reverse the minus sign to a plus sign on the options position.

Remember -- unless you write an option that is deeply in the money (and there are very few reasons why you would ever want to do that), time value will always work in your favor. And if you sell the option with about one month to expiration, you will capture the point in the option's life where the time decay is greatest.

Of course, the options disclosures will try to scare you. They will tell you that your losses are unlimited. In the case of a naked put, that is totally incorrect since the price of the stock cannot fall below zero. While theoretically your losses are unlimited, that will only happen if the stock rises to infinity, which of course is not going to happen. In the case of many ETFs (excluding the most volatile ones anyway), the probability of enormous jumps from one day to the next, from which you could not easily exit your position, is low.

By the way, I only make recommendations in the most liquid ETF options series -- those attached to QQQ and DIA, plus the OEX (which is not an ETF, but instead represents a major index, the S&P 100).

STRATEGY #3: COVERED CALLS AND COVERED PUTS
These two strategies are actually very conservative. Essentially, you are partially hedging a position in the underlying stock or ETF.

A covered call involves a long position in the underlying stock and a short position in a call option on that stock. A covered put combines a short position in the underlying stock and a short put position.

When you look at textbooks and websites that discuss covered calls, they will tell you that these positions are "delta hedged." What does this mean? 

If you recall last week, I discussed the concept of delta. Delta tells you how much the price of your option will move for each $1.00 change in the price of the underlying stock. (Delta changes with every change in price, volatility, and time to expiration, but for small to moderate changes, delta is a good approximation of the price change you're likely to see in an option.) If a call option has a delta of 0.40 (calls have positive delta, and puts have negative delta), then if the stock rises $1.00, the option's price should rise by about $0.40 (this ignores your bid/ask spread of course).

If you hold a delta-hedged position, then you're essentially attempting to keep the total value of your position unchanged. In other words, if the value of your stock rises, then you will look to sell enough options to ensure that the value of your options would fall by the same amount. Your hedge ratio is 1/delta, or in the case of the example shown above (delta of 0.40), it would be 1/0.4. For every 100 shares owned, you would short 2.5 call options.

If you did this, of course, then you would not make any money on your trade. Plus, as far as the exchanges, regulators and your broker are concerned, you would have a short position and would thus need to put up a substantial amount of margin. So instead of holding a delta-hedged position, when selling a covered call you are going to want sell one option for each 100-share position of the underlying stock that you hold.

This may seem a bit confusing at first, so let's go back to QQQ and look at an example of a covered call position. This would entail holding a long position of 100 shares in QQQ and a short position of one call option. In this example, you would buy 100 shares at $35.56 and would sell one December 2003 $37.00 call for $0.60. (Remember, the bid price was $0.60 and the ask price was $0.70. In the first example, you were buying the option, so you had to pay $0.70.)

When you write a call like this, you are indicating that you do not expect QQQ to move above $37.00 during the remaining life of the option. By selling the call option, you are limiting the upside gains you could potentially earn on your long QQQ position. However, your upside potential on this trade is still pretty reasonable. Up to a price of $37.60, you are in just as good shape selling the call as you would be in holding the shares outright. But if QQQ moves above $37.60, then you would have been better off having held a straight long position in the fund.

In essence, writing a covered call gives you the opportunity to earn extra "income" on your long positions. If the price of QQQ falls, or closes below, $37.00 by the third Friday in December, then the call options will expire worthless. You will pocket the premium on the call (what you sold the options for) and will still hold your long position in the fund.

If QQQ starts to fall sharply, and you sell your shares, then you will either have to close the options position (most likely at a substantial profit) or sit with the open, now naked, short call. In this case, your broker will require you to meet margin requirements on the position.

Please note that there is a similar strategy on the bearish side of the coin. If you hold a short position in QQQ, then you could sell a put against that holding. In this scenario, if QQQ falls by a small amount, then you will earn extra income from selling the option. If prices fall enough to make the put in the money on the option's expiration date, then you will be forced to buy the underlying shares, but you will still get to pocket the premium you received when you sold the put option. And, if the price of QQQ rises, then your put sale will at least reduce your losses from the short trade.

SUMMARY
In this week's educational bonus I covered three of the most basic options strategies: outright options purchase, naked option writes, and covered put and call sales. Next week I will cover some more advanced options strategies.

Good trading!

Steven Poser
Editor
The ETF Authority
New York, NY