USING OPTIONS AS EQUITY SURROGATES

In teaching T.D. Waterhouse stock market courses, I’ve become aware that traders often have misconceptions about options.

Individuals who are quick to buy penny stocks regard them as extremely risky and state that "I would never buy options." Some traders, on the other hand, become addicted to options and don’t consider buying the underlying stock even when it is very affordable.

Every so often in this newsletter I will recommend purchasing an equity option as a possible alternative to buying an underlying stock. In previous newsletters, I have recommended options on United Technologies (UTX), Avon Products (AVP) and 3M (MMM). What these securities have in common is that, at least from my point of view, they are all "expensive" stocks.

Avon and United Technologies both trade at around $60 a share and MMM is close to $130. Unless a trader has a very large portfolio, it is difficult to trade these types of stocks in sufficient quantity to make a reasonable profit. This problem can be solved by buying options instead of the underlying stock. I often describe this strategy as treating the option as an "equity surrogate."

What is an option? Please skip this description of basic ideas if you are already familiar with options. If not, read on.

Options can be divided into two categories: calls and puts. Call options give the owner the right to PURCHASE an underlying stock, while put options give their owner the right to SELL an underlying stock. Individual investors generally purchase call options on a stock they believe will increase in value, and put options on stocks they believe will decrease in value.

In more specific terms, a single call option contract gives its owner the right, but not the obligation, to purchase 100 shares of an underlying stock at a specific price on or before a specific date. The specific price is called the "strike" price. The specific time is specified by the particular contract you buy. In my strategy I always purchase options that are not set to expire for at least a few months, so right now I am purchasing October options. All standard equity options contracts always expire the third Friday of each month.

On or before expiration, you can exercise your options. If you bought call options, you can take delivery of the underlying stock. More typically, options are traded before they expire. Even if you buy options that expire in October, you can sell them the next day -- or the next minute -- if you so choose.

I have continually pinpointed 3M Company (MMM) in my "Stocks to Watch" section. The shares fell sharply after being downgraded on Wednesday, April 16th, breaking at $130. The stock then rebounded on Thursday, closing at $129.98.

Let's say that you considered MMM an attractive candidate to buy, but purchasing even 100 shares at just below $13,000 would crimp your ability to take other positions. You could instead buy options on this particular stock.

There are many places to get option quotes on the net. One of the most flexible is http://finance.yahoo.com
After you enter the site, enter the symbol for the underlying stock you are interested in viewing options quotes on. Double click on "Options" and you will be able to view options screens for calls and puts in various time frames.

A very wise trader once told me this about options -- "Buy more time than you think you'll ever need." At first, I resisted his advice, but soon found out it was true. Typically, I like to buy five or six months of time. The cost per option is higher using this approach; however, you can at first be wrong on the direction of the underlying stock and still make money if it moves in your direction over time. I also like to buy options one strike price above where the stock is currently trading. With MMM at just about $130, I focused on the October $135 call. The bid and ask at the close of trading on Thursday, April 17th was $5.60-$5.90.

One of the key advantages of buying options is leverage -- or the ability to dramatically increase your rate of return while investing far less capital than the alternative -- buying or shorting the actual underlying stock. Let’s say you were weighing buying 100 shares of MMM versus buying several option contracts.

Let's say MMM opens at $130 and you buy 100 shares of the stock there. Several days later it rallies back to $135 and you sell. Your profit would be $500 on a $13,500 investment, or +3.7%.

Now let's say you used call options instead by purchasing five MMM October 135 contracts. You pay the full asking price of $5.90. To calculate the total cost of this option, multiply the $5.90 ask price by 100 (remember: each contract represents 100 underlying shares). Each option therefore costs $590, requiring you to make an initial investment of just $2,950 ($5.90 x 100 x 5).

Now let's say MMM goes up to $135 and does so in the next few weeks. My best guess is that the 135 calls would then trade at approximately $8.00 bid / $8.40 ask. Let’s say, then, that you sell at $8.00. Since you bought at $5.90 and sold at $8.00, your profit is $2.10 per contract, or a total of $1,050. In absolute terms this is certainly better than the $500 you would have made by holding the stock. Meanwhile, on a percentage basis you have done INCREDIBLY better. An investment of $2,950 ($5.90 times 5 contracts) has yielded $1,050 in profit for a quick return of nearly +36%!

Are there disadvantages to options? Most definitely. First, options are a "wasting" asset. As they move closer and closer to expiration, their value decreases at an increasing rate. Also, they lose most in percentage terms within the last month of their life. That is the reason I generally avoid "short fuse" options with little time remaining before expiration.

Second, it is important to be aware that almost always in trading options you will need to buy at the ask and sell at the bid. If you were to buy the October 135 MMM contract at the present time, then you would almost certainly pay $5.90. If you changed your mind and decided to sell two minutes later, then you would probably have to settle for $5.60.

The 30-cent spread is far greater than anything you would encounter on even a low-priced stock. This spread means you must be very right when you make an options trade. If the stock just stands still, then you won't break even -- you will likely lose money.

As I stated above, when a particular stock trades at a reasonably low price (for me, below about $40), I usually do not use options. However, options extend the range of stocks I can trade. For me, that extension of the range of choice is an important benefit. Options, so to speak, give me options I wouldn't otherwise have had.

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