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Geoff Garbacz James DiGeorgia

Why all the Excitement about Options?

September 11, 2007

Why all the Excitement about Options?

In the Gold and Energy Advisor, we have been making use of several option strategies.
Despite the success, many of our subscribers have been asking why we would even
consider such a strategy. Aren't options risky? Why bother with something that can
expire worthless? Shouldn't we just buy the stock?

These are certainly fair questions so rather than highlighting a specific strategy this week,
we're going to take a broader view and show you why option strategies are becoming so
popular and why we choose them as one of our primary tools for successful investing.

While there are numerous advantages to options, most can be grouped into one of three
categories. First, significantly less money is spent to gain control of stock. Second,
investors can alter the profit and loss profiles to accept or reject particular risks. Third,
investors can profit from a lack of movement in the stock, which is certainly something
that cannot be done with stock ownership. Let's take a closer look at each of these
reasons in turn.

Reason #1: Less Money Down

If you buy a call option, you have the right, not the obligation, to buy shares of the
underlying stock for a fixed price over a given period of time (up to three years). For
example, if you buy a December Microsoft $25 call, you have the right to buy 100 shares
of Microsoft for $25 per share at any time through the third Friday in December. Because
you are buying a right to buy shares, you only pay a small fraction of the cost of the
stock. If the stock price rises, the value of the call rises as well which means you can
profit on the movement of a stock (just like stock holders) but without spending
anywhere near the same amount of money.

For instance, Microsoft closed last week at $25.61 so you'd pay $2,561 for 100 shares.
However, the January '07 $25 call was asking $1.80 so you'd pay $180 for the right to
pay $25 per share (for 100 shares) through the third Friday in January. Because you're
spending less money ($180 vs. $2,561), you have more money available to invest in other
stocks (or options) thus adding diversification to your portfolio. Options can also be a
great tool for those investors just starting out particularly in IRA (Individual Retirement
Accounts) because of the limited contributions allowed by law (usually $3,000 per year).
For example, an investor with $2,000 in an IRA may not have a lot of choices if he
wishes to invest in stocks. Because of the limited funds, he may forego his "first choice"
stocks and buy others where the outlook is not as favorable.

Options do not pay dividends so that is something you do not get if you buy the option
and is often a criticism of stock investors. However, because option buyers spend less
money to control shares of stock they will earn more interest on their remaining balances
(usually paid monthly) rather than a relatively small dividend (usually paid quarterly). In
many cases, these interest payments amount to more money than the dividend and are an
added bonus if the underlying stock does not pay a dividend.

Investors who buy call options do not ever have to buy shares of the underlying stock.
Using the above example, as the price of Microsoft rises the value of the call option rises
and the investor can simply sell the call option and profit from the increase. It should be
noted that the call option will not rise dollar-for-dollar with the underlying stock until
very close to expiration and that is assuming that the stock's price is greater than the
fixed price at which the investor has the right to buy ($25 for the Microsoft call example).

The main point we are making is that option investors can control the movements in a
company's share price at a fraction of the cost and there are numerous advantages in that
alone.

Reason #2: Alter Your Profit and Loss Profiles

By purchasing options, investors can create unique profit and loss profiles that cannot be
obtained through any other asset. For example, take a look at the following profit and loss
diagram for a long stock position purchased for $50 (red line):

[Image 1]

The horizontal axis shows various stock prices while the vertical axis records the profit
and loss you would have per share. For example, what would your profit be if the stock
rose to $55? Locate $55 on the horizontal axis and then trace a vertical line to the blue
profit and loss line. At that point, trace a line directly to the vertical axis on the left and
you'll see that you would have a $5 profit. The chart shows that if you own shares of
stock that your profit and loss is in a one-to-one relationship with the stock.
 That is, you gain and lose dollar-for-dollar with the stock.

Now let's overlay the profit and loss curve for a $50 call purchased for $3 as shown in
the following diagram (blue line):

[Image 2]

It is easy to see that the $50 call profit and loss line has some favorable characteristics,
mainly that it has a much lower limited loss. In this case, the most the investor can lose is
$3 whereas the stock investor could lose the entire $50. While the profit and loss line for
the $50 call also has a higher breakeven point (it crosses the zero horizontal axis at $53
rather than $50) that is usually considered a worthwhile tradeoff by the option investor.
The option holder gives up $3 in upside profit in exchange for limiting the downside risk
to only $3. Options allow investors to bend and alter the profit and loss curves at various
points. The ability to alter the straight line profit and loss nature of a long stock position
is what creates a powerful dimension to options. Investors can alter their risk-reward
profiles to suit their needs which can include speculation to risk management. So while
an option will expire worthless if the stock's price does not rise above the "fixed price"
(called the "exercise price" or "strike price") it is generally seen as a small price to pay
for the numerous benefits that go along with it.

Reason #3: Profit from a Standstill Stock

Option investors have yet another advantage over stock holders; they can profit
significantly from a lack of movement in the stock. There are many strategies for doing
so but they all, in one form or another, involve the selling of time premium and fall into
the category of "premium collection" strategies. Probably the most well known is the
covered call. With a covered call, the investor buys shares of stock and then writes (sells)
a call option against those shares. By selling a call, the investor has entered into an
agreement to sell those shares if the long call holder decides to buy them. Because the
investor has already purchased the shares, he knows he will always be able to deliver
them if the long call holder decides to buy them. It is the long call holder's right to decide
if he wishes to purchase the shares. In exchange for selling this right, the investor collects
cleared cash that is available for immediate use for anything he wishes. Most covered call
writers sell calls month after month collecting relatively small premiums that add up to
big numbers at the end of the year.

Volatile stocks that move sideways are ideal candidates for covered calls since the great
fluctuations in the stock's price make the option more valuable. If the stock moves sideways over a long enough time period it can be a loss to the stock holder if for no
other reason than the risk-free interest rate that could have been earned on the money had
he not purchased the stock. But the covered call writer can profit significantly often to the
tune of 20% or more by the end of the year and all on a stock whose price has gone
nowhere.

We have been successfully trading options with the Gold and Energy Advisor portfolio.
Hopefully investors who are only familiar with stock investing will now have a better
idea why we choose to invest and hedge with options.