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Demystifying the World of Options

Like politics and religion, options are not a safe topic for conversation in polite company. Entrenched beliefs, misconceptions and different agendas tend to cloud the discussion. The battle lines are usually drawn along the subject of risk, both real and perceived.

As someone who writes an options column, I obviously belong to the camp that believes options are a valuable investment tool that, when properly utilized, can both boost returns and reduce risk. That said, I acknowledge the validity of many of the arguments made against options. Perhaps pointing out the most common pitfalls, rather than proselytizing on the benefits, is the best approach to bring some evenhandedness to the subject.

Operation Manual

As with any tool, before using options, make sure you are familiar with the basic rules and guidelines that govern their behavior. Although one needn't know how to build a combustion engine to drive a car, there is a baseline of knowledge necessary to safely operate the vehicle.

Contract Specifications: Margin requirements (pay special attention to leverage), the exercise and settlement procedures, and what strikes and expirations are currently listed for trading are important to know. For example, you should be aware that index options such as for the S&P 500 (SPX) can only be exercised on expiration day and are cash settled; also note that SPX options actually cease trading on the third Thursday of the month, a day earlier than equity options, though they officially expire on the third Saturday. By contrast, equity options can be exercised at any time during the life of the contract. This is especially important when trading options on stocks that pay dividends.

If you own in-the-money calls on Altria (MO), make sure you know when the ex-dividend date occurs -- you will need to exercise your calls if you want to qualify for the payment. Likewise, if you are short an in-the-money call on a dividend-paying stock, be prepared for assignment and being short the actual shares the day before it goes ex-dividend.
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