Managing Your Portfolio With Options, Part 1

Definitions: A contingent purchase is any options position that may (or may not) lead to purchase of the underlying security. In a long contingent purchase (using calls), the trader has control; and in a short contingent purchase (using puts) the control is given to the trader on the other side of the trade. The term portfolio management refers to any strategy that protects profits, creates a range of choices, or reduces market risks.

The options market: Your portfolio advantage: Why is options trading still a well-kept secret? Many traders avoid options because they are too risky, exotic or difficult to understand. However, in reality options are attractive because various strategies fit a broad range of risk, including highly conservative. These strategies do not have to be exotic; and with a little bit of study the jargon and strategic rules are not difficult for most traders.

Can there be a conservative options strategy? Yes. In fact, there are several. They include the best-known covered call as well as insurance puts, contingent purchase and sell, and limited swing trading. A speculative strategy is not necessarily high-risk, and this is what makes options so versatile. In fact, options trading has been growing at a spectacular rate over the past four decades since public options trading was first introduced.

Only a Few Decades Old

A brief history: The Chicago Board Options Exchange (CBOE) was formed in 1973 specifically to facilitate a market in options. Features such as guaranteed settlement and standardization of price, expiration terms and contract size were important new features that for the first time made it possible to take part in an orderly options market. The Options Clearing Corporation (OCC) was also formed that year to serve as guarantor for every options trade. This was a revolutionary idea. Even so, by today’s standards, the original publicly traded options market was ancient. It offered only calls and no puts, and calls were only available on 16 companies.

Without Internet access and few trained brokers, trading was mostly left to experienced brokers and a few traders. Only those physically on the exchange floor were able to get fast execution; everyone else had to telephone a broker, who then had to phone the floor and talk to a specialist. By the time all of the steps were finished, the fast-moving price of the options might have changed drastically.

Puts were first permitted for trading in 1977. In that year, a total of 39 million contracts traded. (Back in 1973, only 1 million were traded.) Other exchanges also began trading in options, including the American, Pacific and Philadelphia Exchanges. In 2007, 2.86 billion contracts were traded. Over the relatively few years that options have been around, the transaction levels have grown dramatically, as shown in the chart.

In 1982, the market was further expanded by allowing options trading on indexes and the following year, on futures. And in 1990, long-term options, or LEAPS (long-term equity anticipation securities) were developed and marketed, with lives as long as 30 months (listed options last fewer than eight months).

In Part 2 of this series, Michael Thomsett discusses an options trading strategy that you can fit into your own portfolio, called the “Double-Whammy” short put. To read Part 2, click here.

Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes full time.

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