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Learning Department
November 1997

Last month we discussed buying options (LEAPS & "regular"). When considering options, most investors think only of buying options. But for every option bought, someone had to be willing to sell that option. And since the "public" overwhelmingly only buys options, it's mostly "pros" who sell ("write") options. That fact alone should give you pause before hastily lurching into an options purchase because "XYZ is going to the moon"!

Buyers of options enjoy limited risk & unlimited potential gain. Sellers have limited gain & face unlimited risk! Why would anyone volunteer themselves for the latter? Perhaps because 80-90% of all options expire worthless. A floor trader once quipped: "There are people who buy hope & people who sell hope. We on the floor sell hope." A friend who traded on the floor in Chicago once told me: "Always remember, options are designed to expire worthless." Any security can do only 3 things: go up, down, or sideways. The options buyer is betting he cannot only predict direction, but also when. The options seller (also called the option writer) wins if the underlying security goes in the other direction, sideways or doesn't move far enough beyond the strike price during the life of the option to recapture the option premium. That's a lot bigger advantage than the zero/double-zero on a roulette table, yet casinos amass fortunes with that much smaller advantage. Futures trader Richard Dennis once said: "There's a lot less to futures trading than meets the eye." We say there's a lot more to options trading than meets the eye. (As you'll see when we discuss the "pricing" of options).

With all these grim facts, why did we recommend buying Coca-Cola (KO) LEAPS puts in last months example? Because in the situation described, you weren't purely speculating on KO's future price movement, you were buying insurance. You already owned KO. You didn't want to sell because of long-term favourable expectations & for some—the tax man. Insurance isn't free. Yet with options, you'll at times make a profit from your "insurance" policy.

Again using KO, let's assume you were less bearish (too bad!) than we were in our July Flash Bulletin (FB). You knew KO was up 29% in just 14 weeks. Short-term, you thought any further advance would be much slower. KO might go sideways or perhaps even decline a bit. You also wanted the capital tied up in KO working for you regardless. So you sell a call option. It's a covered call because you own the underlying security (KO).

The average price for KO Sep 70 calls for the week after our FB was 3.25. Again using 2000 KO shares as your position, you could sell 20 calls. Total premium received: $6500. If 2 months hence (September 19), KO was at 70 or less, you'd keep the entire premium for a gain of 4.6% (minus commissions). That's 28% annualized. So much for the good news. Bad news is KO was 59 1/8 on September 19. From 70, that's a loss of $10.88/share. Net loss was reduced by the call premium to $7.13/share (34% less than if you hadn't sold the calls). In comparison, the KO '99 70 LEAPS puts were up $6.43 & reduced the loss by 41%. But most importantly, the LEAPS puts provided more downside protection than the written calls. This is the big weakness of the covered call strategy: minimal downside protection. It's a workable approach for squeezing out extra income/gain in "fair weather" markets, but not advisible during current hurricane warnings. (This is #14 in the series Building Wealth the Harry Schultz Way).

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