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Options

We have decided to add options investing (notice I did not say trading) to our armamentarium. We believe that used reasonably it is a relatively conservative strategy that can boost your overall portfolio returns. We will attempt to elucidate our thinking behind any option purchases (or sales) we make. Along the way we hope to increase our knowledge of the option market (as well as anyone else who is interested). A few caveats before we begin. DO NOT invest in anything you do not understand. DO NOT invest anything you can't afford to lose (or would not be willing to lose). Finally, we are by no stretch of the imagiantion option experts. With all of that in mind, let's learn about options.

Our first investment (trade?) is a company we all know well, Cell Pathways. We sold 10 JAN 15 Put contracts at $6.75. I know, I know, that's all great but what does it mean? A Put contract gives the buyer the right to buy a given stock at a set price within a defined period of time. For this right, the buyer pays a premium to the seller. The seller, on the other hand, accepts the obligation to buy a stock (from the Put buyer) at a set price prior to option expiration. Each contract represents 100 shares.

I'm sure the above is "as clear as mud." Let's look at an example (since Cell Pathways is our first option trade we will look at it). We sold January 15 Put contracts. Selling a put means we sold the right for someone to sell us stock in Cell Pathways at a set price. The price we must purchase the underlying stock is fixed at $15 per share (no matter what the underlying stock is doing). This right does not last forever. Instead, it is limited to any time between now and January 1999. The buyer paid us $6.75 per share for the put option. Since each contract represents 100 shares and we sold 10 contracts, we were paid $6750 (10x100x$6.75).

Before you run out to call your broker (not that anyone would), we need to look at the downside. At any time (at least, within the defined period of time) we may be asked to purchase 1000 shares of Cell Pathways for $15,000 ($15x1000 shares). This may happen at a price of $14 15/16 or $0.10 per share. At either extreme, we would be required to purchase 1000 shares at $15. The maximum downside risk is the stock going to zero. If that happened we would be required to pay $15,000 for 1000 shares of worthless stock. Not a good thought!

Before I scare myself, let's discuss the upside. The most obvious is keeping the $6,750 paid as a premium. This occurs if the Put option is NOT exercised (the stock price is over $15). The other possibility is a relative upside. I say that because we end up with the stock. If one are bullish on the stock (as we are with Cell Pathways), this outcome is great. Not only would we own 1000 shares, we own those shares at a cost basis of $8.25 per share ($15-$6.75). The key here is the understanding that one has of the underlying stock.

As always, please research any stock (and/or option) that you plan to invest in. Before doing any option trading, be intimately aware of the fundamental risks. We do believe certain option strategies can be a "conservative" way to participate in stocks that you have a good understanding of.