BOSTON ( TheStreet) -- Options are the best-known derivative securities, but they're little understood.The Black-Scholes-Merton model is the basis for determining option prices. It's complex and nearly impossible for a casual investor to understand or implement. Option prices are subject to several factors, which have been dubbed "the Greeks" after the Greek symbols that represent the factors. The character theta represents time sensitivity; delta, price of the underlying security sensitivity; vega, volatility sensitivity; and rho, sensitivity to the appropriate interest rate. There's a set of "higher order" Greeks based on the values of the first-order Greeks. Getting into options trading is a good way for a novice investor to lose a lot of money. But that doesn't mean options have no place in a portfolio. The most common options strategies are a covered call, which enables investors to gain income even when the stock price isn't moving, and a protective put, which limits losses. Because the basis of every strategy is a combination of calls and puts, it's important to understand the payoffs. A call option gives the buyer the opportunity to acquire the underlying security at the strike price. Those positions gain in value as the stock price increases because the buyer can exercise the option and purchase the security for less than it's currently trading for. On the other hand, the seller must dump the stock at below the market rate and, therefore, take a loss. The price of the option compensates the seller for taking on the risk of having to sell the security below the market price. The more "out of the money" an option is, the cheaper it will be, and vice-versa. A put option is the opposite of a call option. It gives the buyer the opportunity to sell the underlying security to the seller of the option at the strike price. Therefore, the option gains in value as the share price of the underlying security falls. Combining these securities at various strike prices can lead to a huge number of potential strategies. The long-straddle strategy and butterfly strategy are two that could gain credence in the coming months.
The long straddle is best for an investor who expects a stock to either increase or decrease by a significant amount over several months. The above graph shows this strategy applied to Wal-Mart ( WMT). (Option prices can be found on TheStreet.com's quote page.) Wal-Mart's stock is trading around $56, so this straddle was constructed around the option with a $55 strike price and a maturity of Sept. 18. The straddle is constructed by buying a put and a call at the same strike price. This way, the investor benefits from both upside and downside movements at the cost of the two options: $5.40 per pair in this case. The straddle takes a V-shape, gaining when the price increases above or decreases below the strike price. Because the strategy requires the investor to buy two options, the distance between the strike and the breakeven point is greater than if the investor bought a call or put on its own, as can be seen on the graph. Wal-Mart's stock would have to increase to about $60.40 or decrease to about $49.60 for the investor to break even with this trade. If the value moved beyond this range, the investor would gain in either direction. Wal-Mart is a stable stock, so it's not a good candidate for this trade. For the straddle to make money, the stock would have to decrease by at least 11% or increase by more than 8.6% in the next six months. Since the stock gained only 8% over the past year despite a hot market, that's unlikely. A stock like Apple ( AAPL) would be a much better subject of a long straddle. The stock has run significantly over the past year, and the shares could rise or fall by a substantial amount between now and September on news about new products or sales. Since Apple is more volatile, the options are more expensive. As a result, the straddle would cost $12.81 to enter into at a strike price of $220. Apple's stock would have to decrease to $207 or increase to $233 for the straddle to make money, but that's easily attainable. If the company introduces a new iPhone or posts phenomenal iPad sales, the shares could jump. On the other hand, if Apple misses targets on the iPad and nothing new happens in the next six months, the shares could slide below $200. Either way, the straddle would allow the investor to profit from Apple.
The butterfly trade is much more complicated than the straddle. It involves buying two call options, one at a low strike price and one at a high strike price, and selling two more call options at a strike price between the strike prices on the long-call positions. As the graph above shows, this results in a payoff that rewards the investor when the stock doesn't move much. If the stock does change by a larger-than-expected amount, the downside is capped at the net cost of the options. That's a much more appropriate strategy for Wal-Mart, since it rewards stability in share prices. The butterfly constructed in the graph is based on buying Wal-Mart calls with a strike price of $45 and $60 and selling two calls with a strike price of $52.50. This strategy would pay off if the stock increased by less than 3% or decreased by less than 12.7%. The trade can be shifted up or down to accommodate a greater upside or downside movement to suit the investor's expectations. Apple wouldn't be a good candidate for this trade. Wal-Mart, however, may keep trading in this range since the company has consistent performance. Options enable investors to capitalize on different stock-market expectations than equities. Given the volatility in the market over the past year, many stocks would likely be solid candidates for a straddle trade. Bigger names with low beta values, however, are likely to be better suited for butterfly trades. -- Reported by David MacDougall in Boston.