Options Basics January 26, 2009

Option  A contract sold to one party (holder) by another party (writer).  The contract offers the right, but not the obligation, to buy or sell a specific security at a specific price at a specified date in the future.  Two basic types: calls and puts.

Call Options  An option contract that gives the buyer the right, but not the obligation, to buy a specific stock at a specific price at a certain date in the future.  An investor would want to buy calls if he is bullish on a particular security.  An investor might sell calls if he believes that a particular security will go down.

Uses of a Call Option  Writing covered call options on securities that you own allows you to generate income from your holding, but also limits the extend to which you benefit from a rise in the stock.  Buying call options might not be a bad strategy if there is a situation where you believe that a particular stock will either rise significantly or go to zero. In this case, if you bought the stock you might make a decent return, but you could also lose your investment. If you instead bought the option, you could still lose your money, but you could make a lot more if the stock rises.

Put Options  An option contract that gives the buyer the right, but not the obligation, to sell a specific stock at a specific price at a certain date in the future.  An investor who expects a particular security to go down in value would want to buy a put.  Conversely, an investor who expects a particular security to rise might consider selling a put.

Uses of a Put Option  If you own a position in a stock and you are concerned about it falling in value, you could purchase a put option as a form of insurance to protect you on the downside.  Selling a put option could also be used as a “profitable” limit order, provided that you would be willing (and able) to purchase the shares at the strike price.

Risks of Options  Based on short-term price fluctuations.  “Trading” options is not likely to be a profitable endeavor.  Potential for large gains and losses.  Selling uncovered calls.

Trading Options  In order to buy and sell options, you must get approval from your broker.  There are several different levels of approval, each of which allows you to make more complicated trades.  The levels are similar, but slightly different from broker to broker.

Types of Options  European: Can only be exercised at the exercise date.  Bermuda: Can be exercised at predetermined (i.e. the end of the month) dates until the exercise date.  American: Can be exercised at any point before the exercise date.  However, most options expire unexercised. That is, they are unwound before expiration.

Option Quotes  Options are usually quoted in 100’s of shares on a price- per-share basis.  There are different options for different strike prices and maturities.

Club Portfolio Update  Total Value of $20,  48 Shares of DOW  52 Shares of CORE  106 Shares of CODI  $17, Cash

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