Okay, so what's up with options?

Options? OK, here we go.
Everyone is afraid of options and futures. First things first. Options and futures are not the same thing, but unfortunately people lump them together quite often. And as such, they think that both are very risky. This is absolutely false. For me Options are a way to reduce or eliminate risk and maximise profit.
However for certain people options can be as dangerous as a Vegas casino. So , , , if you've got the gambling bug , , , please please, don't read any further because you are the people that options traders prey on. And I do mean to use the term "prey".

I have a love for trading and for capitalism and for freedom and especially for America. There will always be people that abuse their freedoms. But that is at the heart of freedom isn't it? That is part of the cost of freedom, among other more consequential things. But in this country we have a right to waste our money by making risky and stupid speculations. If you want to waste yours, then jump right into options and futures without taking the time to educate yourself. Conversely we also have the right to educate ourselves and take advantage of opportunity. That, is precisely what options provide, opportunity. With the caveat of self education firmly in place, I can honestly say that Options are much less risky than most other investments. So what are Options?

(As I am writing this I am listening to Martin Sexton; Black sheep, and understanding that if I keep on with my explanations this might be part I of II)( But I will attempt to shorten it).

The Purpose of options is insurance. Plain and simple, nuthin' more nuthin' less.
This insurance allows entrepreneurs to hedge their positions, take on and manage risk, invest capital with less downside risk, expand into new markets with relative impunity, protect themselves from unexpected market conditions, natural and man made, etc.

Without getting into too much detail, here is an actual legitimate, capitalistic use of options and futures. This actually happened recently and the trader that did this had his or her 5 minutes of fame.

Southwest Airlines had forecast higher energy prices (fuel prices) and entered into a trade that guaranteed that they could buy fuel at a set level. No matter what fuel prices rose to. They guessed right!

This was a smart trade, but to guarantee that price, they had to pay a premium.

In essence they said, "I'll pay you a fee, if you guarantee to deliver fuel to my airlines at today's prices, if, and only if the price rises on or before a set, future date. If the price doesn't rise in that time frame, you keep the fee and the contract expires.

That Is a contract, No?
Yes it is.
It is an option contract.

But what if prices fall?

Had prices gone the other way, they would have given up the premium and just paid the lower fuel prices in the market, and then explained to the boss that the insurance policy had expired and it was time to renew it with another further dated policy(option).

Would the boss be angry about the loss of the premium? Probably not. Are you angry when you don't get into a traffic accident and don't "get" to use your auto insurance? Of course not, this was a legitimate business expense and a correct and prudent use of Options

On the other side of that trade was a legitimate speculator willing to take the risk that oil had peaked and wouldn't go higher. Guess what? They lost! Big time! They were buying oil at $140 to provide Southwest oil at a ridiculously low price. OUCH! There are, of course, many more details that went along with this trade and it is far more intricate than this simple explanation. The point is in the legitimacy and necessity of Options, the people that use them and the speculators that provide them.

This happens every day with Corn, Cattle, Pork, Cotton, Wheat, etc. It is what makes your food, clothes, auto parts, lumber, etc. so cheap and readily available.

Not so evil, the speculators? Huh?

One other feature of options;
Lets say a wing crack develops in one airplane (purely hypothetical) and the FAA decides to come in and ground all of Southwests' airplanes, for inspection. They no longer need the fuel in question, right? So what happens to the contract? Remember the clock is ticking and the speculator is only responsible to payoff "on or Before" the set date. That contract premium is becoming less valuable, in time value, every day. The genius of options is that you can sell the contract, it's transferable to another party! They have the right to sell that contract to someone who does need that fuel. Now that the contract is"in the money" (meaning that oil prices have already increased within the specified time frame), that premium would rise accordingly due to it's "intrinsic" value(the dollar value of getting cheap fuel) even though the time value is dwindling daily

So this is essentially the purpose of Options, but how do you and I trade them? The safest, easiest and most important way to do this through the use of covered calls. And this is the topic for my very next blog, see you then.

JT