recent stockhouse article

As promised here is the article I wrote recently:

Title: Options Trading, Friend or Foe?

A good many people may know or understand a thing or two about investing in stocks, but when it comes to options many don’t find them an accessible trading tool. I want to help introduce people to the wonderful world of options. My focus will be on some of the strategies I use and to demonstrate that options are a great tool for active and maybe passive investors. I will focus mainly on Canadian options but will add in the occasional US option just for fun.

I would first like to establish a baseline of understanding for options before proceeding. Without this basic knowledge what I say will look like a foreign language.

First off options are a derivative meaning they derive their price from something such as a stock or index price. An option is a contract that gives the buyer the right to purchase the underlying security at a predetermined (strike) price. Options are priced with a set formula, which is fairly complex and uses current: interest rates, stock price, dividends paid, volatility and remaining time to expiry. Some basics terms and points to know about options are:

· An options expiry date is always the 3rd Friday of the stated month
· Strike price indicates the price that you are willing to buy or sell the stock
· A stock’s volatility is a measure of its movement up and down in a given time period
· Time and intrinsic value are important to understand (see websites below)
· Premium is the price paid for the option
· Options trade in contracts (or lots) and 1 lot controls 100 shares of the underlying stock
· Both call and put options can be bought or sold (selling is more risky and requires a margin account)

For a better understanding on definitions please visit www.optionetics.com . For US option quotes I use http://moneycentral.msn.com/investor/research/welcome.asp and type in the symbol then click on the left where is says options. The msn site shows a nice view of time value in its own column to help see the difference between intrinsic (actual) and time values. Another US site worth mentioning is www.cboe.com .

I will quote primarily US sites for educational purposes because frankly, Canada has very few besides the Montreal exchange home page. One Canadian website I’ve found is www.optionmatters.ca . This is an interesting site that contains educational tools and a weekly blog.

In Canada, the Montreal exchange is where options are traded. I go to the Montreal exchange home page www.m-x.ca/accueil_en.php to find out what stocks currently have options. Currently the Montreal exchange has over 140 stocks and several ETF’s (exchange traded funds) with more being added as options increase in popularity.



Let’s use an example to make options easier to understand. My current strategy involves buying call options that have some intrinsic value or ‘partially in the money’ with at least a few months time to expiry. This means the stock doesn’t need a large move up for me to make money and that I have allowed time for it to move, hopefully in my chosen direction.

Biovail, (BVF-T) is an option I am currently trading.

I bought 5 calls (controlling 500 shares) @ Jan $16 2008 for $2.3 each contract.

Buying a call option is a bullish strategy where the buyer is betting the stock price will go up. The Jan indicates that this option expires Jan 18th 2008, which is the third Friday in January. The $16 is what I will pay per share assuming I exercise my rights and buy the stock from the seller. On Jan 18th my break even point will be $18.30. My total paid was $1150 for control over 500 shares. I left out commission but my CIBC account costs me $8/trade and $1.25 per contract. This trade cost me $14.25 to buy, which is close to 1% of the trade value.

I bought these calls on Aug 10th when the stock was trading @ $17.25. So I paid $1.25 intrinsic value and I paid$1.05 time value. Dividing the stock price into the time value lets me know that I paid roughly a 6% premium for this option. This is ok with me because BVF is at or near the bottom of a 3yr chart, which shows me it has some good technical support around these levels.

BVF last traded at $18.05 on Aug 28th and the option was worth $2.8 each. So, if I were to sell today I would make about $220, which sounds like peanuts but let’s look closer. I have now paid $1178.5 including trade costs and sold for $1400. That’s about 18% return on capital in less than 1 month!

I have control over 500 shares of BVF that would cost me $8500 to purchase without the use of an option. This strategy frees up capital to buy stocks that have no options. I am also able to control more shares of higher priced stocks that would otherwise be unobtainable for me.

I am limiting the amount invested into this call option strategy to a max of 10% of my trading capital. This ensures that most of my capital is safe so I can live to trade another day. I am ok (but not happy!) if I lose $1100 and know that my max loss will be no more, but at the same time my possible returns are huge!

If BVF went back to its June glory days around $25 that would net me a return of about $3300 or 300%. On my trading capital of about $20k this would be a gain of 16% while only risking 5% of my capital. Now, does this risk/reward strategy sound like a good way to beef up your overall returns risking only small amounts of your total investment capital?

As always do your homework or DD before putting any of your hard earned money at risk. I hope this helps to expand your knowledge on options and that you can consider them a viable ‘option’ to simply just buying the stock. In my next article I would like to share my first experience trading options and what I learned the hard way!

This article was my attempt to make options clear as mud. Hope this helps.

Taxing options.

I had a rough idea how options were taxed, but I posed the question to someone with more experience than I. The response I received was good and stated that he was NOT an accountant. How I understood it was that most of us can include options into our capital gains or losses.

Unless you are a very active trader, and very good, the chance of you paying anything other than capital gains taxes on your options profit is slim. However the government does leave room for interpretation. One thing to note is that if you don't derive the majority of your income from trading options it doesn't make sense for the government to waste time with you.

The government would not want to make bad options traders pay the full tax rate on their options trading because that could wind up lowering the total taxes paid. Not exactly in the governments best interests. I think the odds of the government allowing bad option traders to write off losses against regular income is about as likely as a decision to no longer tax income trusts in 3 years.

One thing the person I asked about taxing options did say is that 'Native' Canadians would do better putting options into regular income. Don't ask me, but it has to do with Native Canadians paying more capital gains tax than regular tax?

The feedback i received about tax on options was from a few people, with most of it coming from optionmatters.ca writer Richard Croft. If one ever has a question about options Mr. Croft seems to be an excellent source of knowledge, and doesn't mind sharing it!

I have written an article on options and published it on stockhouse.com. I figure that it should be posted here for background knowledge to learning about options. Look for it in the near future.

I will be looking at doing some option trading in the next week or two as October options will expire Friday Oct. 19.