Tarkblog

I’ve been wanting to toy around with options for a while now.

Like a lot of other people, I feel like I know a bit about investing even though it isn’t something I had any formal training on or do on a daily basis. Options trading, however, is something I am clueless on. That doesn’t mean I can’t do it, however.

In order to get a little smarter with it, I decided to put $1000 into a Tradeking account so I could “play” with some options trading.

Now, there are a bajillion types of options, but let’s stick to the basics for now. The most basic type of options are “call” and “puts”. Calls mean you think the underlying stock price will go up; put is the opposite.

I had a hunch that CMI, which is Cummins, would be going down. The beginning of 2007 was looking shaky for the diesel industry, and I was guessing that it would have an effect on the stock price. Just before the end of the year, the stock price was at around $120, already down from its previous high of around $140. I felt good about it going even further down, at least for the short term.

So, I bought a February put option for $110. The overall logistics of options is a bit more complicated than I’m going to explain here, but in a basic sense by buying that option (called a “contract”) it gave me the right to SELL Cummins stock at a price of $110 anytime before the option expired, which is the third friday of February.

Now, if the stock price is hovering around $120 it doesn’t make any sense for me to sell it at $110. Not only would it be for a loss, but also because I didn’t own any Cummins stock to sell. I would have to buy it first (at the market price) and then I could sell it at $110. That would be a loss of $10 a share. The options contract is a contract on $100 share, meaning that if I exercised the option right then I would have lost $1000.

But that’s not the point. As the stock price falls, it becomes more attractice of an option. And, if the stock price were to fall below $110..well..that would be great. See, if the price fell to say, $105, then I could quickly buy 100 shares at $105 and sell them right back at $110 (the option I bought allowed me that right). That would be a quick $500 profit.

Now, you don’t have to buy and sell ANY stock in order to make money with options. The options you buy have a price associated with them that’s based on the price of the stock, the volatility of the market, and the time left until the option expires. The option I bought cost $.90 a share, or $90 (plus a broker commission of around $6). All in all, it cost me $100.

But at any time I could sell that option BACK to the market and give someone else that option. The price of the option fluctuates just like the price of the stock. If the stock price goes down, the my option starts looking better and better and starts becoming worth more. I could just sell it back to the open market and make money that way as well.

Now, this is all sound and good except for one thing. Cummins stock is currently at $139.34. It has gone up $20 since I bought my option, and that has drive the market price of my option down. It’s currently selling for $.05, meaning you could buy it for $5.00 whereas I paid ~$90 last month.

So unless Cummins stock takes a huge nosedive in the next couple of weeks, it looks like my option will have been a bad investment. But that’s the point; this is part of my learning. At least it only cost me $100 and not considerably more!

I’m currently trying to decide what’s up next. What are you bearish/bullish on?

This entry was posted on Saturday, February 3rd, 2007 at 3:29 pm and is filed under Random Thoughts. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.