Probably for you, won’t even think of buying any options, probably no need to read the following, but just like you would buy insurance when you go travel, you probably would like to buy insurance for your stock as well.

As mentioned in a mail before, I have been practicing on options for more than a year, and when I am still learning. I would like to share with you the walls I hit on options. 

First of all, to recap, the value of options:

Current option value = Intrinsic value + Future value

Like to buy call on A at $50, and now A is $55, intrinsic value is $5 and the future value depends on the volatility and the time remains, the larger the both, the more the future value it is.

So far, I guess only 10% of my options are for hedging (others are just seeding for some extreme profit), which I know is not a good practice, however, I always wanted to do more on hedging but always couldn’t meet the right price… 

The first lesson:

Qualcomm (QCOM) call at $37.5 Oct 2006, I bought in May 2006 at $10, and I sold it at Sept 2006 for $2. (Kennis probably will go to hit me after reading this… :P) In US, one contract of options means 100 of it. In that case, is losing $8x100 USD. The problem was QCOM was in lawsuit with Nokia and Broadcom after I bought the option, and the <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />peak of QCOM was over $50 last year. Therefore, my expected value of that earning from option is $50 - $37.5 - $10 = $2.5. Of course it turned out the recovering cycle of Qualcomm is longer than I expected. Even now, last night rose over %4, it is still <$40. So as many people said, Options is super high risk, like I lost %80 of in this case. 

The first lesson I learn from it is Options is not like Stock, it would be too naïve to put $10 for $2.5, which also means for me, as a learner, would probably like to buy options <$3 for current value.

Note: In case of hedging, the price of options could of course be higher, since option at the money (near the strike price) would have a higher future value, which means the longer you hold it for hedging, the more you may lose. However, if option is not near the strike price, which means higher the intrinsic value, hence the option price. 

The second lesson:

Research In Motion (RIMM) call at $70 Sept 2006, I bought in June 2006 at $4, and I sold it at Aug 1006 for $6. Sounds great to have 50% return? Yes, same for me at that time… Actually after some buy and sell, I got 3 contracts at one time, and for the last one I held, the price of that option was pure earning, and my expected value of RIMM was $90, the stock was low because of some lawsuit at the beginning of the year. But because of shadow of QCOM, I sold it more than 1 month before the expiration. In Sept 2006, RIMM was $88 (intrinsic value was $18), and now RIMM is $138 (could earn $60 from the option), yes, 1000%~!!! For sure, I don’t like gamble, since anything could happen. However, I learned another lesson.

The second lesson was if the price of the stock wouldn’t really reach what you expected, you could wait longer or actually could swap option of lower price one. i.e. I could have sold the option at $6 and bought another one strike at $75 for $1 to hold longer. 

Of course, after some trials, and learning, I also have some proud trade like SIRF and Sony Options, and also I am now hedging the earning option. It is like riding bicycle, once you get to earn, you can protect by buying put options, and if it falls, you can buy call options when put options already protected your initial earning… The good thing of option is you don’t need to pay $75 to buy the chance of RIMM to grow from $75 to $138, within a defined period; you can pay $5 for that chance.

However, options requires more of arithmetic, after you know them, it is as simple as stocks. 

Eric