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Demystifying the World of Options

Most ETFs pay dividends. Some, like the SPDRs (SPY), pay out on a quarterly basis on the last business day of the month; others, like the Diamonds (DIA), make monthly distributions. The point is, knowing the basic rules by which the various vehicles operate will help you avoid potentially costly surprises.

Options Pricing: While option-pricing models can be very complex and one does not need to understand all the math involved, the two components that I think are essential to have a basic understanding of are implied volatility and time decay. For example, be aware that before an earnings or news report, the implied volatility of the near-term or front-month options usually increase to a higher level than the later-dated months. If you think Google (GOOG) will hit $400 in the next year, it makes no sense to buy calls that have only two weeks remaining until their expiration and only two days before the company is scheduled to report earnings. Instead, buy some LEAP options.

Pick the Right Tool: Make sure you understand the strengths, weaknesses and risks involved in each specific strategy. More importantly, make sure you then pick the strategy that best aligns with your investment thesis and will help accomplish the specific goal set for each trade or investment decision.

In a recent article , Jim Cramer, gave an example of using in-the-money calls as a replacement for buying shares of the underlying stock in what is commonly referred to as a replacement strategy, which can reduce risk and boost returns.

In an article last year , I constructed a theoretical portfolio consisting of eBay (EBAY), Broadcom (BRCM), Yahoo! (YHOO) and Qualcomm (QCOM), comparing the costs, risks and potential rewards of owning 100 shares of each vs. one at-the-money call with six months until expiration. The cost or risk of owning the options was about a fifth of owning the shares, while the potential reward become nearly equal once the stock climbed 10% or more. One important point made in the article is that when using a replacement strategy, only buy the number of option contracts that represents the number of shares you would be willing to purchase.

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