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Options are a high-risk investment, but they are also highly profitable. Traders enter the option market for many reasons. One reason is because the amount of capital required to enter the market is lower than regular stock. The fact that most options move faster (volume) and produce higher returns is another reason traders dabble in the option market. Many brokerage houses limit the amount of cash (margin) new traders can use to invest because of the market's high potential for loss. As option traders become experts, these limitations go away, and the trader is free to invest as much as their account allows. Once a new trader gets familiar with how the option market works, they can become an expert in no time at all. Stock vs. Option Regular or preferred stock is an asset. In other words, stock is equity, and it gives the holder ownership in the company where it's drawn from. It trades easy in the exchange because, like money, investors consider it a liquid asset. An option is a derivative of stock. This means that its value completely depends on the value of the equity associated with it. Option Buyers: Option buyers own a contract that says they have the right to buy or sell an asset by a certain date (expiration date). Option buyers are not obligated to buy or sell the asset, and if they choose not to, they let their option expire as it becomes worthless. Option Sellers: Option sellers own a contract that obligates them to buy or sell an asset by a certain date (expiration date), if the buyer excercises the option. Most option sellers hope the buyer's contract expires, so they can collect premiums. Online Brokers Most investors trade options using an online broker system that connects directly to the brokerage house holding trader's investment account. Traders send orders through their broker, which go directly to an exchange. Their brokerage house, which has a seat on the exchange floor, receives the investor's order and sends the trader's request to auction after deducting or adding funds to their investment account. All this takes place in real-time, which occurs in a matter of seconds. Expiration Every option expires. Traders call an option's expiration date, the strike date, because it stands as a marker where all options must be either be bought or sold. On or before the strike date, the trader can either choose to exercise the option and buy the underlying asset, or they can let the option expire, where its value then becomes worthless. Strike Price, Exercise & Assignment An option's strike price is the value an investor will pay to exercise their right to buy or sell the option. If a buyer chooses to exercise the option, the brokerage house assigns the seller's assets to the buyer's account. Margin Requirements Margin is the total amount in which an investor can use to make a trade. Most traders make a deposit at a brokerage house, which serves as collateral for buying and selling options. Normally, the trader can only buy or sell options up to the balance available in their account (margin). Sometimes, brokerage firms extend credit to the trader, which adds on to their margin's limit. However, if at any time a trader buys an option on credit (borrowed margin), makes a bad choice, and their option starts to lose value, the brokerage house has the right to immediately sell the option to cover the margin (margin call). Order Entry Home broker systems basically have two types of transactions, buy and sell. Investors can fine-tune their orders by adding details to the order, including limit, stop or market, which directs their broker on how to specifically auction it. Types of orders In each of the two types of order entries, there are two types of orders that a trader can place. Call Orders Buying a call option - Trader buys a call option thinking its price will go up (long-buying). Buying the underlying asset is not an obligation. Selling a call option - Trader sells (writes) a call option thinking its price will go down (short-selling). Trader must sell the underlying asset, if a buyer exercises the option. Put Orders Buying a put option - Trader buys a call option thinking its price will go down. Selling the underlying asset is not an obligation. Selling a put option - Trader buys a call option thinking its price will go up. Trader must buy the underlying asset, if a buyer exercises the option. Moneyness Moneyness is the real value of an option. An option starts to lose value the minute it enters the market. The closer it gets to its expiration date, the less it's worth. Investors call this occurrence time decay. Intrinsic value is simply the difference between an option's strike price and the underlying asset's market price. Option traders calculate moneyness by adding an option's intrinsic value to its time decay value. NEXT: [thread=11548]Call Option[/thread]

A call order is one of two types of orders that an option trader can make (the other being a put order). The trader can either choose to buy a call option or sell one. Buyer: The call option buyer has the right to buy the underlying asset, but is in no way obligated to do so. The call option buyer can choose to either exercise his right to buy on or before the call option's strike date, or they can let the option expire. Seller: The call option seller (writer) has the obligation to sell the underlying asset at its strike price, if a buyer exercises their right on or before the option's expiration date. The seller receives a premium (option market price) from the buyer for taking this risk. Both buying and selling call options are high-risk investments, with traders who buy taking the higher gamble. A trader may ask, if call options are so risky, why do investors buy and sell them? The answer is in the return, because even though the risk is high, call options can give investors high profits when performed correctly. What Is a Call Option? A call option is a contract that's connected to an underlying asset, normally a stock or commodity. Every call option contract has a fixed price (strike price) that each trader must honor on or before a fixed date (strike date). The terms and responsibilities under the contract differ depending on whether the trader is the buyer or the seller. Buying a Call Traders who buy call options are betting that the market price of the underlying asset will go up. Call options carry a premium, which varies depending on price and how close the purchase is from the strike date. Usually, one call option contract gives the buyer the right to buy 100 shares of the underlying asset. A call buyer pays a premium for each share covered under the call contract. If the asset's market price exceeds the call option's strike price, the call buyer will exercise his right to buy the shares. If the market price is lower, they will just let the option expire, resulting in a loss in whatever they paid in premiums. Example: GE is trading at $48 (market price) 1) Option Available: GEJan50($5) = 100 shares of GE stock at $50/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $5. 2) Call buyer has $5500 in their investment account. 3) Trader buys 1 call option at $500 (100 x $5 (premium cost)). Result one: GE hits $70. The call option buyer exercises their right to buy 100 shares at $50. Their total investment is $5,500 ($5000 shares + $500 premium). They immediately sell their 100 shares for $7000, resulting in $1500 profit (300%). Result two: GE hits $30. The call option buyer lets the contract expire, does not exercise their right to buy and loses the amount of premiums paid. In this example, the option buyer would lose $500. Selling a Call Traders who sell call options are betting that the market price of the underlying asset will go down. Call options carry a premium that goes directly to the seller. If a call buyer does not exercise their option, the call seller keeps both the asset and the premium. On the contrary, call option buyers who exercise the option, obligate the call seller to sell the underlying asset. There are two types of call sales. A covered call is a sale in which the seller actually owns the asset. Traders make naked calls when they do not own the underlying asset. Naked calls have the highest risk and only expert traders should carry out this kind of strategy. Covered Call A covered call is a win-win strategy for traders who have the capital to own the underlying asset. Covered call sellers make a profit when the market price goes up and buffer losses when it goes down, by writing the call option with a strike price higher than its market price. Example: GE is trading at $50 (market price) 1) Call seller has $5000 in their investment account and buys 100 shares of GE. 2) Call seller writes the option: GEJan52($2) = 100 shares of GE stock at $52/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 3) Call buyer buys the option and call seller receives $200 in premiums. Result one: GE hits $70. The call option buyer exercises their right to buy 100 shares at $52. The call seller sells at $5200 and receives $400 profit ($200 in premiums + $200 from price) Result two: GE hits $40. The call option buyer lets the contract expire. In this example, the option seller would keep the asset, keep $200 in premiums, but would suffer a $1000 loss from the asset's current market price. The total loss reduces to $800 when adding the premium. Naked Call Options This type of call option is one of the highest risks a trader can make. It involves writing a call on an asset that is not owned. The naked call writer will need to buy shares if the call buyer exercises the option. Example: GE is trading at $50 (market price) 1) Call seller writes the option: GEJan52($2) = 100 shares of GE stock at $52/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $5. 2) Call buyer buys the option and call seller receives $500 in premiums. Result one: GE hits $70. The call option buyer exercises their right to buy 100 shares at $52. The call seller needs to buy 100 shares to cover the option and pays $7,000. They deliver the shares and receive $5,200 from the call buyer, resulting in a loss of $1,800. The total loss reduces to $1,200 when adding the premiums received at the beginning of the sale. Result two: GE hits $40. The call option buyer lets the contract expire. In this example, the option seller would keep the asset, and make $500 in profit from premiums. The lower a naked call seller's strike price deviates from the asset's market price, the higher premium the seller will receive, but if the buyer exercises the option, total loss also increases. NEXT: [thread=11599]Put Option[/thread]

A put order is one of two types of orders that an option trader can make (the other being a call order). The trader can either choose to buy a put option or sell one. Buyer: The put option buyer has the right to sell the underlying asset, but is in no way obligated to do so. The put option buyer can choose to either exercise his right to sell on or before the put option's strike date, or they can let the option expire. Seller: The put option seller (writer) has the obligation to buy the underlying asset at its strike price, if a put buyer exercises their right to do so on or before the option's expiration date. The seller receives a premium (option market price) from the buyer for taking this risk. Investors who own assets can also buy and sell put options to protect their investment. Put selling and put buying have different functions and earn profits for investors in different ways. What is a put option? A put option is a contract that's connected to an underlying asset, normally a stock or commodity. Every put option contract has a fixed price (strike price) that each trader must honor on, or before, a fixed date (strike date). The terms and responsibilities under the put contract differ depending on whether the trader is the buyer or the seller. Buying a Put Traders who buy put options are betting that the market price of the underlying asset will go down. Put options carry a premium, which varies depending on price and how close the execution is from the strike date. Usually, one put option contract gives the buyer the right to sell 100 shares of the underlying asset. A put buyer pays a premium for each share covered under the put contract. If the asset's market price retreats from the put option's strike price, the call buyer will exercise his right to sell the shares. If the market price is higher, the trader will just let the option expire, resulting in a loss in whatever they paid in premiums. Example: GE is trading at $20 (market price) 1) Put Option Available: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) Put buyer has $2200 in their investment account. 3) Trader buys put option for $200 (100 x $2 (premium cost)). Result one: GE hits $10. The put buyer buys 100 shares at the market price for $1,000. Then, they exercise their right to sell the 100 shares at $20 for $2000. Their total profit is $1,000 ($2000 shares sold - $1,000 shares bought). The investment nets $800 profit (400%) after subtracting their $200 in premium costs. Result two: GE hits $30. The put option buyer lets the contract expire, does not exercise their right to sell and loses the amount of premiums paid. In this example, the put buyer would lose $200. Protective Put Buying Traders who own assets listed at auction and who are waiting for the market price to go up (going long), can buy put options to protect their investment if the market price should unexpectedly fall. Example: GE is trading at $20 (market price), and the trader owns 100 shares. 1) Put Option Available: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) Trader buys put option for $200 (100 x $2 (premium cost)). Result one: GE hits $10. Their stock loses $1000. The put buyer buys 100 at the market price for $1,000. Then, they exercise their right to sell 100 shares at $20 for $2000. Their total profit is $1,000. This offsets their loss and decreases it to only $200 after adding premiums paid. Result two: GE hits $30. Their stock gains $1000. The put option buyer lets the contract expire, does not exercise their right to sell and loses the amount of premiums paid. In this example, the option put buyer would sill gain $800 after deducting premiums. Selling a Put Traders who sell put options are betting that the market price of the underlying asset will rise. Put options carry a premium that goes directly to the seller. If a put buyer does not exercise their option, the call seller keeps the premium. On the contrary, put option buyers who exercise the option, obligate the put seller to buy the underlying asset at tthe strike price. There are two types of put sales. A covered put sale occurs when the seller actually owns the asset. Traders make naked puts when they do not own the underlying asset. Selling puts have a highest risk factor and only expert traders should carry out this kind of strategy. Covered Put A covered put occurs when the trader owns the underlying assets for sale and is shorting them at auction. Covered put sellers make a profit when the market price goes down or breaks even. Significant losses occur if the market price rallies. Example: GE is trading at $20 (market price), and the trader owns and shorts 100 shares. 1) Put seller writes the option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) A put buyer buys the option and put seller receives $200 in premiums. Result one: GE hits $10. Their short stock gains $1000. Put buyer exercises the option and the put seller uses the $1000 to buy 100 shares at the market price from the buyer. The put seller makes $200 from the premiums. Result two: GE hits $30. Their short stock loses $1000. The put option buyer lets the contract expire. In this example, the put option seller would suffer an $800 after subtracting the premium. Naked Put Options (Uncovered) This type of put selling involves writing a put option on an asset that is not owned. The naked put writer will need to sell shares if the put buyer exercises the option. Example: GE is trading at $20 (market price). 1) Put seller writes the option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) A put buyer buys the option and put seller receives $200 in premiums. Result one: GE hits $10. Put buyer exercises the option and obligates the seller to buy 100 shares at $20, so they pay $2000 for stock worth $1000. The put seller loses $800 after adding premiums. Result two: GE hits $30. The put option buyer lets the contract expire. In this example, the put option seller would gain $200 from premiums collected. NEXT: [thread=11598]Strike Price[/thread]

Options are easy to understand once a trader is familiar with the language and how each term functions in real-time. An option's strike price plays a major role in options trading, as it acts as the center piece in which many other factors revolve around it. The strike price is part of the equation that determines an option's real value (moneyness). Once an investor becomes comfortable in understanding a strike price's significance, they can quickly find an option's value, which helps them make faster decisions in real-time trading. Strike Price Defined The strike price is the price that a trader will buy or sell the underlying asset associated with their option when it's exercised. Traders who do not exercise their option on the expiration date, discard the contract, as it becomes worthless. Option traders will only exercise their option, if it will bring them a profit Example: 1) Underlying asset: General Electric common stock (Symbol: GE) trading at $20 on 1/15 a) Option Holder 1: GE January call option, expiring on 01/15 with a strike price of $18 (Symbol: GEA18) b) Option Holder 2: GE January call option, expiring on 01/15 with a strike price of $20 (Symbol: GEA20) c) Option Holder 3: GE January call option, expiring on 01/15 with a strike price of $22 (Symbol: GEA22) Result: Option Holder 1: On or before January 15, the holder will exercise the option and pay $18 (strike price) for an asset worth $20 (market price), instantly making $2 on the transaction (before subtracting premium costs). Option Holder 2: This holder would break even and would lose only the premiums paid if they exercise the option. Option Holder 3: The holder would discard the option, as exercising it would result in an automatic intrinsic value loss. Their loss is the premiums paid to buy the call. Strike Price vs. Market Price In using a call-buy as an example, the farther the market price of the underlying asset is from a call option's strike price, the higher the premium (the option's price). To understand how the market prices an option, traders need to understand the relationship between its strike price and market price (moneyness). An option's worth depends on two values, intrinsic and time. Intrinsic value This value is simply the difference between the market price and the strike price. A call's strike price that exceeds its market price has no intrinsic value. Example: 1) Underlying asset: GE currently trading at $20 a) Call Option 1: GEA18, strike price at $18 has an intrinsic value of $2 ($20-$18) b) Call Option 2: GEA22, strike price at $22 has $0 intrinsic value ($20-$22) Time Value Simply put, options are a dying asset, meaning that its value slowly decreases starting from the moment it enters the market. Trading experts call this occurrence time decay. The closer an option gets to its expiration date, the less it is worth. Investors calculate time value by subtracting the option's price from its intrinsic value. Time value is equal to an option's price when it has no intrinsic value. Example: 1) Underlying asset: GE currently trading at $20 a) Call Option 1: GEA18 trading at $3.50, strike price at $18 Result: This option has an intrinsic value of $2 and a time value $1.50 ($3.50-$2.00). Its premium cost is $3.50. b) Call Option 2: GEA22 trading at $.75, strike price at $22 Result: This option has an intrinsic value of $0 and time value $.75 ($0.75-$0). Its premium cost is $.75. Summary Understanding a strike price's function leads to better trading. Once an option trader becomes a strike price expert, calculating values become a snap in the fast-moving, real-time world of online trading. NEXT: [thread=11597]Option Premium[/thread]

An option premium is the amount that a buyer pays or the seller receives for one option contract. Premium values fluctuate throughout the life of the contract and reach zero after the option expires. The fluctuation depends on how close the option's strike price is to the underlying asset's market price, and how close an option is to expiring. Traders calculate premiums by adding the option's intrinsic value to its time value. Option Premium for Buyers Premiums determine how much a buyer will pay for one option contract. The premium's function works the same for both call and put buying, and its cost reduces the amount of profit taken from exercised options in-the-money (ITM). For options that expire out-of-the money (OTM), the total premium costs will equal the total amount the buyer will lose on their investment. Example: 1) Buyer purchases one put option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) Buyer pays $200 (100 (shares) x $2 (premium cost)). Result one (ITM): GE hits $10. The put buyer buys 100 shares at the market price for $1,000. Then, they exercise their right to sell the 100 shares at $20 for $2000. Their total profit is $1,000. The premium costs cut their profit to $800 profit after subtracting the $200 they paid to enter the market. Result Two (OTM): GE hits $30. The put option buyer lets the contract expire, does not exercise their right to sell and loses the amount of premiums paid. In this example, the put buyer would lose a total of $200. Option Premium for Sellers Sellers use premiums to find the amount they will receive for one option contract. The premium's function works the same for both call and put selling. For options that settle ITM, premium costs will equal the total amount the seller will gain on their investment. For options that expire OTM, premium costs will reduce the amount the seller will lose on their investment. Example: 1) Seller writes one put option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) Seller receives $200 (100 (shares) x $2 (premium cost)). Result one (OTM): GE hits $10. Put buyer exercises the option and obligates the seller to buy 100 shares at $20, so they pay $2000 for stock worth $1000. The put seller loses $800 after adding premiums. Result Two (ITM): GE hits $30. The put option buyer lets the contract expire. In this example, the put option seller would gain $200 from premiums collected. Intrinsic value This value is simply the difference between the market price and the strike price. A call's strike price that exceeds its market price has no intrinsic value. Example: 1) Underlying asset: GE currently trading at $20 a) Call Option 1: GEA18, strike price at $18 has an intrinsic value of $2 ($20-$18) b) Call Option 2: GEA22, strike price at $22 has -($2) or $0 intrinsic value ($20-$22) Time Value Simply put, options are a dying asset, meaning that its value slowly decreases starting from the moment it enters the market. Trading experts call this occurrence time decay. The closer a $0 intrinsic value option gets to its expiration date, the less it is worth. Investors calculate time value by subtracting the option's trading price from its intrinsic value. Time value is equal to an option's price when it has no intrinsic value. Example: 1) Underlying asset: GE currently trading at $20 a) Call Option 1: GEA18 trading at $3.50, strike price at $18 Result: This option has an intrinsic value of $2 and a time value $1.50 ($3.50-$2.00). Its premium cost is $3.50. b) Call Option 2: GEA22 trading at $.75, strike price at $22 Result: This option has an intrinsic value of $0 and time value $.75 ($0.75-$0). Its premium cost is $.75. NEXT: [thread=11596]Moneyness[/thread]

Moneyness is the real value of an option. Investors calculate an option's trading price by adding its intrinsic value to its time decay value. To determine if an option is in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), a trader must compare the underlying asset's market price to the option's strike price. Intrinsic value This value is simply the difference between the market price and the strike price. A call's strike price that exceeds its market price has no intrinsic value. Example: 1) Underlying asset: GE currently trading at $20 a) Call Option 1: GEA18, strike price at $18 has an intrinsic value of $2 ($20-$18) b) Call Option 2: GEA22, strike price at $22 has -($2) or $0 intrinsic value ($20-$22) Time Value Simply put, options are a dying asset, meaning that its value slowly decreases starting from the moment it enters the market. Trading experts call this occurrence time decay. The closer a $0 intrinsic value option gets to its expiration date, the less it is worth. Investors calculate time value by subtracting the option's trading price from its intrinsic value. Time value is equal to an option's price when it has no intrinsic value. Example: 1) Underlying asset: GE currently trading at $20 a) Call Option 1: GEA18 trading at $3.50, strike price at $18 Result: This option has an intrinsic value of $2 and a time value $1.50 ($3.50-$2.00). Its premium cost is $3.50. b) Call Option 2: GEA22 trading at $.75, strike price at $22 Result: This option has an intrinsic value of $0 and time value $.75 ($0.75-$0). Its premium cost is $.75. In-the-Money To determine the moneyness of call and put options, a trader must look at their intrinsic values. ITM options are more expensive then ATMs and OTMs because of their positive intrinsic values. Finding out if a call or put option is ITM is easy, once a trader learns how to calculate the difference between the two. ITM Call Options If a call option's strike price is lower than the underlying asset's market price, then the call option is ITM. This means that call options with intrinsic values of $.01 or more are ITM. Example: Underlying asset: GE currently trading at $20 Call Option ITM: GEA18, strike price at $18 has an intrinsic value of $2 ITM Put Options If a put option's strike price is higher than the underlying asset's market price, then the put option is ITM. This means that put options with intrinsic values of -($.01) or less are ITM. Example: Underlying asset: GE currently trading at $20 Put Option ITM: GEA22, strike price at $22 has an intrinsic value of -($2) Out-of-the-Money Out-of-the-Money options have no intrinsic value. Their values only reflect time decay, and they lose value as they get closer to the option's expiration date. The farther an OTM option deviates from the underlying asset's market price, the less it is worth. OTM options carry a high risk of expiring worthless. OTM Call Options If a call option's strike price is higher than the underlying asset's market price, then the call option is OTM. This means that call options with intrinsic values of -($.01) or less are OTM. Example: Underlying asset: GE currently trading at $20 Call Option OTM: GEA22, strike price at $22 has an intrinsic value of -($2) OTM Put Options If a put option's strike price is lower than the underlying asset's market price, then the put option is OTM. This means that call options with intrinsic values of -($.01) or less are OTM. Example: Underlying asset: GE currently trading at $20 Put Option OTM: GEA18, strike price at $18 has an intrinsic value of $2 At-the-Money Rarely does an option have the same underlying asset price as its strike price. When this happens, the option is ATM for both calls and puts. ATMs, like OTMs, only have time decay value, with an intrinsic value at exactly $0.00. Example: Underlying asset: GE currently trading at $20 Call Option OTM: GEA20, strike price at $20 has an intrinsic value of $0 NEXT: [thread=11595]Options Expiration[/thread]

Investors consider options dying assets because their value slowly decreases starting from the moment they enter the market. Every option expires, and all options must be bought, sold, or exercised on or before its expiration date (strike date). When an option expires, its value becomes worthless. Companies are not obligated to offer options every month. Expirations run in cycles, and it's important for traders to understand how they work before buying and selling options. Lifespan of an Option An option enters a chain once an exchange assigns it a cycle. Starting from the beginning of the cycle, traders can buy, sell or exercise the option at anytime before its strike date. The ask bid spread determines whether an option will trade easily. Options running closer to their expiation date move faster than those farther away. Example Call option chain: GEA20 (strike date 1/15), GEB20 (strike date 2/15), GEC20 (strike date 3/15), Result: On 1/10, option GEA20 will trade faster (more liquid) than GEB20. Option GEC20 will hardly move at all. Traders wanting to enter the market fast will need to choose from listings in GE's, "A" cycle Option Expiration Cycles Options always run in four-month cycles. In the past, companies could only offer stocks in the current quarter. Due to the demand for short-term hedging, exchanges introduced long-term equity anticipation securities (LEAPS) into the market, which allowed companies to list options year-round. Only popular and liquid stocks offer investors LEAPS options. Options traded in more than one expiration cycle (LEAPS) must follow the four-month cycle rule. Exchanges assign stocks an option cycle depending on the month that the company offers their first option. January cycles (JAJO) = Expirations in Jan, Apr, Jul and Oct. February cycles (FMAN) = Expirations in Feb, May, Aug and Nov. March cycles (MJSD) = Expirations in Mar, Jun, Sept and Dec. Example: On December 5, GE decides to offer options starting in January. Their exchange will automatically assign a JAJO option cycle to the option chain. Expiration Codes: A=Jan, B=Feb, C=Mar, D=Apr, G=Jul, J=Oct If GE does not offer options every month the chain will look like: GEA20, GED20, GEG20, GEJ20, running on a JAJO cycle If GE offers options every month the chain will look like: GEA20, GEB20, GEC20, GED20, running on a JAJO cycle Cycle Chains vs. Consecutive Month Chains Companies are not obligated to offer stock options every month. However, if a company offers options, the first two listing in their cycle must be the current month and month that follows. The remaining two listings will depend on the expiration cycle assigned by the exchange. Example: On January 5, the following options are available: 1) GE Option Chain: GEA20, GEB20, GEC20, GED20 2) Ford Option Chain: FordA20, FordB20, FordD20, FordG20 Expiration Codes: A=Jan, B=Feb, C=Mar, D=Apr, G=Jul Result: GE offers options every month, Jan-April. Ford offers options in Jan and Feb, but they don't offer them again until April or July. The exchange obligates Ford to offer options in January and February because the current date is 1/5. Ford's option cycle is JAJO, which forces the company to list their last two options to expire in April and July, which completes the cycle. Finding the Expiration Cycle The first two months in an expiration cycle do not identify the cycle. Investors must look at the third month in an expiration cycle (JAJO, FMAN or MJSD) to find which cycle the option is trading on. If the third month is January, the fourth month in the cycle will be the option's expiration cycle. Example: Expiration Codes: A=Jan, B=Feb, C=Mar, D=Apr, K=Nov, L=Dec 1) GE Option Chain: GEA20, GEB20, GEC20, GED20 In this example, GEC20 (March expiration) is the third option in the chain. This expiration cycle is a March cycle or MJSD cycle, 2) Ford Option Chain: FordK20, FordL20, FordA20, FordB20 In this example, FordA20 (January expiration) is the third option in the chain. Because LEAPS end in January, to find the chain's expiration cycle, an investor needs to look at the fourth option in the chain (FordB20). The expiration cycle in this example is a February cycle or FMAN cycle. NEXT: [thread=11594]Exercise & Assignment[/thread]

When an investor buys an option, they have the right to exercise it at any time before it expires. After a buyer exercises their option, the brokerage house assigns the obligation to seller's assets. The strike price is the value an option seller (writer) will use when buying or selling shares to meet their obligations. Exercising Options Buyers purchase call orders or put orders in the options market. The buyer then has until the day the option expires (normally 30 days) to exercise it, sell it or let it expire. Option buyers are not obligated to exercise their contract, but if they choose to do so, they obligate the writer to either buy or sell assets to cover the contract. Assigning Call Options (Obligating a Sale) Traders who sell call options are betting that the market price of the underlying asset will go down. Buyers can exercise their contract at any time when the market price is above the option's strike price. Once exercised, the Options Clearing Corporation (OCC) assigns the obligation to "SELL" shares to the writer at the strike price. If the writer does not own the shares, they will need to buy them in the open market at a price higher than the strike price to cover the sale. Example 1) Call seller writes the option: GEJan50($2) = 100 shares of GE stock at $50/per share (strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) GE's Market price hits $60 and buyer exercises the option. 3) The OCC assigns the "SELL" obligation to the writer. Results one: If the writer owns the shares (covered call), they simply sell them to the buyer for $50 to cover the contract. They will receive $5000 and will keep $200 in premiums. Results two: If the writer does not own the shares (naked call), they'll need to buy 100 shares at the market price of $60 to sell to the buyer. The total the writer will pay is $6000. They only receive $5000 from the sale, incurring a total loss of $800 after adding the premiums collected earlier. Assigning Put Options (Obligating a Purchase) Traders who sell put options are betting that the market price of the underlying asset will rise. Buyers can exercise their contract at any time when the market price is below the option's strike price. Once exercised, the Options Clearing Corporation (OCC) assigns the obligation to "BUY" shares from the writer at the strike price. If the writer does not own the shares, they will need to buy them from the seller at a price lower than what they're worth. Example 1) Put seller writes the option: GEJan50($2) = 100 shares of GE stock at $50/per share (strike price), expiring on 1/15 (strike date) with a premium cost of $2. 2) GE's Market price hits $40 and buyer exercises the option. 3) The OCC assigns the "BUY" obligation to the writer. Results one: Traders who short sell their shares write put orders (covered put), to protect (hedge) them. When the market price hit $40, their short shares gained $1,000 in intrinsic value. The writer then sells their shares at market value for $4000. Adding the $1,000 they gained from the short, they use the $5000 to cover the contract. They receive their 100 shares back and keep $200 in premiums. Results two: If the writer does not own the shares (naked put), they'll need to buy 100 shares from the buyer at $50, paying $5,000. Unfortunately, the shares are only worth $4,000 (market value). The $200 in premiums collected earlier reduce the $1,000 loss to $800. NEXT: [thread=11592]Finding an Options Broker[/thread]

To trade options, an investor must open an account with a brokerage house that has a seat on the trading floor of an option exchange. Traders can choose to open their account with a personal (full-service) broker, online (discount) broker or a broker that offers both services. Personal brokers offer traders more help, but they charge more in commissions and fees. Online brokers are cheaper but they only offer limited support. Some brokers offer both full and discount service, giving the trader a choice when placing their orders. A broker's quality of service depends on the broker themselves and varies throughout the industry. Personal Brokers Traders use a personal broker when they seek financial advice or need a human being to place a buy or sell order for them. Most traders do business with personal brokers by telephone. Personal brokers can guide an investor, who is new at trading options, in placing their orders correctly. They also can give a trader advice before placing orders, and they can help a trader come up with an investment strategy that fits their needs. Personal brokers charge three to five times more in commissions and fees than online brokers. Personal brokers are useful when traders do not have a computer or an internet connection available to place an order. Online Brokers Traders familiar or comfortable with option trading can place orders themselves using an online broker. Sometimes called home broker, this system provides a direct link between the options trader and the exchange floor when executing their buy and sell orders. The home broker is a do-it-yourself type system that does not give traders financial advice, but rather provides the tools for traders to find the information on their own. Discount brokers build a variety of tools into their home broker systems, which include real-time streaming, order entry windows, historical financial data indexes and real-time graphic analysis. Order execution speed and online sever availability depend on the chosen discount broker's quality of service. Broker Fees and Commissions All brokers, both personal and discount, charge commission fees. Traders add these fees into buying costs and deduct them from their profits. In other words, each time a trader places an order or uses personal broker services, the brokerage house charges a fee. A trader should consider commission fees when developing their investment strategies. Is Cheaper Better? Most traders think that the best option broker is the one that charges the lowest commission fees. Lower fees are great when an investor works with low margins, but they are worthless if the broker's quality of service is inferior. When finding the best options broker, traders should consider other factors that affect order handling, including server capability, speed of order transmission to the exchange floor and the overall user experience of the broker's online ordering system. Server Availability Online brokers use servers to handle their online traffic. Some servers are larger than others, and the home broker's service availability depends on the brokerage house's infrastructure. Low broker fees are not an advantage if the trader cannot place their orders when they want. Home Broker User Experience Traders need to place their orders fast and easy. Their home broker system should be easy to use, simple and straightforward. The system should offer the trader a single order entry window that gives them alternatives in placing their orders, which include placing stop orders, short selling, placing market orders, covering calls and placing limit orders. Order Execution Traders who buy and sell orders need their orders to execute. Once executed, the trader needs to feel at ease that their broker will guarantee the price executed on the order. Some home brokers do not guarantee that executed orders will have the best available bid-ask price available. The National Best Bid or Offer (NBBO) requires brokers to meet SEC requirements, which give traders the best-quality service. Options traders should look for discount brokers that exceed NBBO standards. NEXT: [thread=11554]Options Chains[/thread]

An option chain is simply a list of buy and put options available for trading. Companies listed in world stock exchanges must meet certain criteria to list options in an options exchange. In most cases, only large to medium business qualify to offer stock options to investors. Most online traders can find stock options by getting a price quote for the stock that they're interested in. Inside the quote, investors should see a link to an option chain, if the company offers options for trading. Example: 1) Investor wants to know if GE lists options. 2) Trader logs into their broker and gets a quote. 3) Quote window returns GE selling at $20 with a checkbox for options. 4) Investor clicks box and an option chain appears. Option Chain Layout Every broker has their own format for listing options. Traders who are unfamiliar with option chains can understand most layouts once they are familiar with the terms and sections that appear in every chain. Brokerage houses must list basic information for every call and put option. This includes listing the option's symbol, strike price, option type, last bid price, ask-bid spread, underlying security market price and expiration date. Underlying Asset and Option Information At the very top of most option chains rests the underling asset's stock symbol, its current market trading price and the option's expiration date. This information applies to every call and put option in the chain. Reading Calls and Puts in an Options Chain Most broker systems list call options on the left side of a chain window. Put options show up on the right-hand side. Chain windows list in-the-money options first in the call section and last in the put column. Broker systems usually highlight options that are in-the-money, so that traders can easily find them. Understanding the Strike Price in an Options Chain Most option chains list the strike price in a column between calls and puts, since the strike price is the same for each one. Its price declines in intervals, depending on the market price of the underling asset. Traders can usually find call and put options with strike prices in intervals of 2.5 to 10 points. Option Symbols Before computers, an option symbol contained a lot of information. Traders could find the name of an underlying asset, the expiration date and strike price just from reading the symbol's numbers and letters. Today, the option chain erases the need for understating symbols, since all the information is already listed in the chain itself. It's still a good idea for investors to grasp the ideology of option symbols, for when a computer is not available. Example: GEA40 GE = 1 stock option for GE stock A = January expiration date (listed A-L, with L for December) 40 = Strike price Last Bid Price and Ask-Bid Spread The last bid price is simply the price of the last transaction for that option. The transaction could have occurred a day ago, a few hours ago or just a few seconds ago. Time of the last bid depends on an option's volume and volatility. As traders place orders in auction, the prices that they ask to buy and sell become the bid-ask spread. Popular options have thinner spreads. Traders who want to enter or leave the market quickly should look for options with smaller gaps between the ask and bid price. The more the option exchanges hands (liquidity), the faster orders will execute. On the contrary, option chains with larger bid-ask spreads have a lower trading interest, creating larger gaps between the buy and sell prices. NEXT: [thread=11553]Order Entry[/thread]

When traders want to buy or sell options, they must place an order with their broker. Most traders do this online by simply choosing an option from an options chain and clicking the order icon. A separate window opens up, and the investor can add additional details and instructions before sending the order to auction. An order will only execute after it meets all the trader's conditions. Quantity, Price and Duration After confirming the underlying security, expiration month and the strike price all order entries require the trader to choose quantity and price. One contract equals 100 options. The amount a trader can invest depends on the balance in their investment account (margin). An option's cost depends on the quantity multiplied by its price. The profit (or loss) taken from close orders also depends on quantity and price. The following order entry on a call-buy order would cost: Quantity: 10 contracts (1000 options) Price: $2 Total cost: $2,000 (before commission costs) Duration falls into order entry fine tuning, where a trader designates exactly how they want their order executed. Fine-Tuning Orders An investor can add more instructions to their orders, which can accommodate their investment strategies and prevent a loss in capital or leakage. Market Order Using this type of order, the trader's request executes immediately. Investors use market orders to get into the market quickly. The downside to this is that the investor must take the price given at execution. In low volume auctions, prices can vary considerably. Limit Order Placing these types of orders puts traders in full control of the buying or selling price. The order will not execute unless the option's market price hits the amount on the order request. The disadvantage to this type of order is that a trader's request may not execute, which would leave them out of the market. Also, a trader's order may only partially execute when placing limited orders. Stop Orders Sometimes investors like to limit or control their losses when they guess wrong. Placing a buy or sell stop order tells investors exactly how much they will lose if an option's market value swings in the opposite direction. Traders can request both market and limited stop orders. Immediate-Or-Cancel Order (IOC) Traders add this order entry along with their limit orders. It tells the broker to buy or sell immediately when the market reaches the designated price. Any shares that do not execute are automatically canceled. Fill-Or-Kill Order (FOK) This order entry is the opposite of an IOC, telling the broker to either execute the quantity immediately or cancel the entire order. A FOK order insures that a trader gets the price and quantity they're looking for. GTC Orders (Good 'Til Cancelled) This order entry tells the broker to reenter the order automatically in the next trading period, if it does not execute. A trader must access the order and cancel it to erase it from further entry into the market. Market-Limit on Close This order entry tells the broker to execute at the closing bell on the exchange floor. The order will execute at the option's last bid price. Market-Limit on Open Orders with this entry will execute at the start of the auction at the option's opening price. NEXT: [thread=11552]Options Transactions[/thread]

Trading options is the same as trading regular stock. There are only two types of transactions, and in each one, traders can either buy or sell. For simplicity, the examples below reflect buying and selling options before the expiration date without exercising and assigning. Opening Transactions This type of transaction occurs when an option trader enters the market. The trader can either Buy-to-Open or Sell-to-Open. Buy-to-Open (Buying a Call Option: Going Long) When traders think the market price of an underlying asset will rise, they can buy a call option to enter the market. This strategy is known as "going long," where traders expect to sell the option for more in the future before it expires. Example: Buy 100 call options on Oct.1 at $5 each = $500 Sell 100 call options on Oct.15 at $10 = $1000 Total profit ($500=$1000-$500) Sell-to-Open (Selling a Call Option: Short Selling ) Traders can also sell (write) a call option when think the market price of an underlying asset will rise. This involves selling options and collecting a premium for taking the risk. The asset involved is either owned (covered put) or not (naked put). Selling-to-Open is known as "going short." Example: Sell 100 options valued at $5 each Option expires Total profit ($500) Closing Transactions These transactions occur when traders exit the market. The two types are Buy-to-Close and Sell-to-Close. Buy-to-Close (Buying a sold Call Option: Covering/Exiting short) Option traders who exit short sales need to buy back the options they sold when entering the market to cover their short positions. Hopefully, the trader buys back at a price close to what they paid. Sell-to-Close (Selling an Owned Call Option: Exiting Long) On the flip-side, traders exiting long positions will need to sell their call options to close. In this case, a trader will want to sell at a higher price than the option's purchase price. NEXT: [thread=11551]Types of Orders[/thread]

Placing an option order in a broker system is fairly straight forward, if a trader just wants to simply buy and sell. What most traders don't know is that they can tweak their orders to accommodate their investment strategies and avoid missing execution of their order (leakage). Traders hate when they miss a buying or selling opportunity due to an order not meeting demand during an auction. With a bit of knowledge on how to fine tune an option order, traders can rest easier knowing that the market will execute their request as planned. What is an option order? Whenever an investor wants to enter or leave the options market, they must place an order. Home broker systems send orders electronically to the market floor, where the stock market executes them, or not, at auction. An option order enters an auction list by price and time of day the trader placed the order. The more an option trades hands (volume), the better the chance an investor has to buy or sell it. Orders that are closer to an option's market price execute faster than those farther away. Example: A trader wants to buy 100 options at $10.00 each. The investor places an order-to-buy in their home broker online system, where the brokerage house withdraws $1,000 from the investor's account and sends their request to auction. Let's say the market price is $9.99 and rising, and the investor's order is third on the auction list at $10.00. In a market order, as soon as the option's market value hits $10.00 or more, the investor's order will execute. If the investor placed the option order at $15.00, most likely the option's market value would not have reached the traders request by the end of the day. In that situation, the order would drop out of the auction, and the home broker would return the money back to the trader's investment account at the end of the day. The Four Types of Orders Basically, there are four types of orders, open, close, buy and sell, which are grouped as follows: Buy-to-Enter the market: An investor buys options thinking the market price will go up. Sell-to-Leave the market: An investor sells their options once the market price hits the investor's target. Sell-to-Enter the market: An investor sells options, owned or to be purchased later for sale, thinking the market price will go up. Buy-to-Leave the market: An investor buys options to cover short positions. Fine-Tuning Orders In each of the four cases above an investor can add more instructions to their orders, which can accommodate their investment strategies and prevent a loss in capital or leakage. Market Order Using this type of order, the trader's request executes immediately. Investors use market orders to get into the market quickly. The downside to this is that the investor must take the price given at execution. In low volume auctions, prices can vary considerably. Example: 1) Market Order: buy 500 call options when it hits $10 = $5,000 2) Auction: 200 options available at $10, 100 at $10.20, and 200 at $10.30 Result: 500 options purchased immediately, regardless of price, resulting in multiple transactions totaling $5,080 (instead of $5,000) Limit Order Placing these types of orders put traders in full control of the buying or selling price. The order will not execute unless the option's market price hits the amount on the order request. The disadvantage to this type of order is that a trader's request may not execute, which would leave them out of the market. Also, a trader's order may only partially execute when placing limited orders. Example: 1) Limited Order: Buy 500 put options at $10 =$5,000 2) Auction: 200 options available at $10, 1,000 at $9.99 Result: Partial execution resulting in buying only in 200 options for $2,000 (instead of $5,000) Stop Orders Sometimes investors like to limit or control their losses when they guess wrong. Placing a buy or sell stop order tells investors exactly how much they will lose if an option's market value swings in the opposite direction. Traders can request both market and limited stop orders. Example: 1) Trader places an order to buy 100 call options at $10 = $1,000. 2) The order executes. 3) Trader places a limited order to sell 100 call options at $15 = $1,500 ($500 profit). 4) Not sure if the market is stable, they also place a limited stop order for the 100 options at $9 =$900. Result: If the market falls, the stop order will execute at $9, and the investor will lose only $100 (1,000 - $900). The trader will also need to cancel their limited order at $15. Otherwise, a brokerage house could consider it an open-to-sell order (buying a put). NEXT: [thread=11550]Margin Requirements[/thread]

A margin requirement is the minimum balance a broker house requires an investor to have in their account when writing call or put options. The requirements vary depending on the broker and the terms agreed upon when opening the account. Every bank account has a balance and the balance increases when the owner makes deposits and decreases with withdrawals taken from the account. Investment accounts act in the same way except traders call their account balance "margin," because their broker uses it as collateral to cover their trades. Option traders can sometimes borrow money from the brokerage house to increase their margins or cover orders when they are short on cash. Borrowed margins have even stricter requirements, cost more when adding interest charges and can be called sooner by the broker, if the investment loses significant value. How to Calculate Margin Every brokerage house has different margin requirements. In general, brokers only let traders write options on a 10%-20% margin (balance in the investment account). If the investment does well their margin increases. If the trade goes bad, the brokerage house sells the option (margin call). A margin call occurs the instant an option drops below the trader's margin requirement, covering the trade and minimizing loss. Margin requirements fluctuate as the market price moves up and down from the strike price and the requirement increases when short selling. Initial margin requirements are: 100% of option proceeds, plus 20% of underlying security value less out-of-the-money amount, if any minimum requirement is option proceeds plus 10% of the underlying security value proceeds received from sale of call(s) may be applied to the initial margin requirement after position is established,*ongoing maintenance margin requirement applies,*and an increase*(or*decrease) in the margin required is possible For simplicity, assume that GE's market price is at $20 in all the examples below. Selling a Call (Shorting) Example 1) Investor wants to sell (write) 10 GE-January call options, expiring on 02/15 with a strike price of $20 for $1 Result: The option trader would need 20% of the total market value of the securities in case the buyer chooses to exercise the option. This amount works out to $5,000 but since he was paid $1,000 for this option the trader only needs $4,000 in his account to place this call order. Selling a Put (Shorting) Example 1) Investor wants to sell (write) 10 GE-January put options, expiring on 02/15 with a strike price of $20. (Symbol: GE JAN20). Result: Again, the option trader would need 20% of the total market value of the securities in case the buyer chooses to exercise the option. This amount works out to $5,000 but since he was paid $1,000 for this option the trader only needs $4,000 in his account to place this call order. Borrowing on Margin Sometimes an investor needs more money to make a trade. When the trader has a good credit standing, they can ask their broker to lend them the funds needed to place an order. The broker house charges interest on top of the loan. Profits from borrowing on margins decrease significantly because the trader splits gains with the broker house. The borrower's risk also increases because the broker house will always get paid back, if the investment goes bad. Example 1) Call option available: 10 GE-January call options, expiring on 02/15 with a strike price of $20, and premium of $2. (Symbol: GE JAN20) 2) Investor wants to buy 10 call options at $2 = $2,000. 3) Investor only has $1,000 on margin and asks his broker to lend them $1,000 at 5% interest. Result: The margin requirement is $1,000. If the option's market value decreases $1,000, the broker will call the option and sell it immediately to cover the loan. The investor's account will hit $0, and they will need to deposit more funds to make future trades and to pay interest due to the broker. Margin Calculator Provided by CBOE is this useful online tool that calculates the exact margin requirements for a particular trade. NEXT: See our Options Forum

This is, in my opinion, one of the best technical analysis books out there. The approach of Richard Wyckoff was developed in the beginning of the century and it still applies. He shows you, in great details, how through price, volume and trend lines you can identify what a stock is doing and what it is about to do. And he did all of it by hand!!! The system is pure and, if combined with other indicators, moving averages, etc. can be powerful. The book is full of technical information. It is condensed, not an easy read but worth every penny and it is one of the least expensive books out there. I highly recommend it.

Secured Investment Contracts are a unique type of bond - but for most people, these bonds are like nothing you've ever invested in before. Like stocks, these bonds allow you to invest in some of the best companies in America. But unlike stocks, you'll always know exactly when and how much you'll be paid. The bonds I'm going to tell you about are as profitable (or more so) than stocks... come with less risk... and have an exact date on which you'll be paid. As you'll learn, it's the company's bondholders, who hold the legal, first claim to a company's income stream. Stockholders come in around eighth in line. It's possible to double our money in these safe and stable bonds… often in a few short years. Most common-stock investors are lucky to make a fraction of that return consistently. What To Do We look for two major things in a good investment: safety and a high return. We use bonds to find them. When a corporation needs money to pay bills, expand, or upgrade equipment, it can fund these activities with the cash coming in the door, by issuing stock (also called "equity"), or by borrowing the money by issuing debt. This is also called "issuing bonds." As an owner of a company's common stock, you share in the company's future profits. If a company you own stock in grows its profits by a factor of 10 over a few years, chances are good your stock will be worth a lot more than your original purchase price. As a bondholder, you have no claim on the company's profits. You are simply loaning money at a set rate for a predetermined period of time. You are entitled to get your money back plus interest payments according to a federal statute that governs bond agreements. In other words, your gains are bound by U.S. federal law. Most people find it incredibly difficult to consistently select stocks that grow their profits (and stockholder's equity) over a long period of time. For every huge success like Starbucks or Home Depot, there are scores of bankrupt dreams. And when a company goes bankrupt, the stockholders can lose every cent they have in the company. This is why I love being a bondholder. In the event the company gets into trouble, the bondholders are at the head of the line when it comes to paying bills and creditors. And in the event of an all–out bankruptcy, the assets of the company are sold, and the proceeds are paid to the secured creditors and bondholders. This legal right to be paid is the bedrock of this investment philosophy. As bondholders, we don't have to guess who has the best widget or which style of clothing people will like from year to year. We just loan money. We simply have to tear through a company's books and determine if it can pay us off in the time period our bonds are "in play." Why It's Possible To Do This Economic theory says we have to take on greater risk to earn greater returns. I disagree. The stock and bond markets make temporary mistakes. Even the smartest investors can get carried away with their fear and greed… which leads to the "mispricing" of risk. If risk were always properly priced, there would be no investment opportunities for me to tell you about. Investors like Warren Buffett wouldn't be able to buy cheap assets and earn huge returns. In fact, the high returns we can earn are possible because of a significant mispricing of risk. And the market is littered with bonds mispriced by the majority of investors, both professional and amateurs. Two factors create this mispricing. First, most big bond-market participants – like insurance companies and pension funds – can't buy the types of bonds we want to buy. These institutional investors are prohibited from investing in the part of the bond market where we operate. This market is commonly known as the high-yield, or "junk," bond market. A high-yield bond is considered riskier than bonds called "investment grade." Don't worry though… as I'll show you in a moment, we'll use this perception of increased risk to make a lot of money. This lack of "big competition" in the high-yield bond market lets us find great deals without much competition. Think of it like this… if you're one of the few mortgage lenders in a town, you could be very picky about the loans you extend to borrowers. You don't have much competition, so you could demand high rates of interest and plenty of collateral to back your loans. Second, the high-yield market is relatively small and carries a stigma of low quality, which is not always deserved. The quality of a loan is determined by analyzing each individual borrower. As I mentioned, Moody's and S&P often make errors in rating bonds, leading to mispricing in the bond market. Wall Street simply bypasses the forest and leaves a lot of strong trees for us to investigate without much competition. The bonds we want to buy could be called "contrarian bonds." Much like a share of stock, a bond can be sold by investors who are afraid of holding the asset. For instance, in 2008, we bought a bond issued by the Goodyear Tire and Rubber Co., America's largest replacement tire maker. At the time, most investors heard "tires" and ran screaming... assuming if the U.S. auto industry was in desperate straits so must the tire business... But they were wrong and this created our opportunity. Since investors were worried about the outlook for tire makers, you could have bought a contract that entitled you to a payment of $1,000 from Goodyear for just $740. That's right. You paid $740 to get $1,000. Here's how this is possible... How to Make the Biggest Gains in Bonds Just like stocks, bonds trade in a public market that is heavily affected by emotions. And just like stocks, emotions can cause bonds to trade for less than their true value. Professionals call this true value the "intrinsic value." When investors become concerned about a business or industry, they're willing to pay less for the debt obligation of that business… just like they're willing to pay less for a dollar's worth of earnings of that business. Let's say company ABC borrowed $5 million three years ago by issuing 5,000 bonds worth $1,000 each. (Most bonds are issued at $1,000 per bond. This original issue price is called the "face value.") The company agreed to pay its creditors 8% interest for five years. That's an interest payment of $80 per bond each year. The amount borrowed, the interest rate, and the life of the bond can vary greatly. But we're keeping it super simple for our example. Now… let's say ABC is struggling due to new competition or an industry downturn. The bonds ABC issued that originally had a value of $1,000 will fall. Investors aren't as rosy about the company's prospects… so they're only willing to pay $800 per bond. Here's where it gets profitable for you and me… We do a thorough analysis of ABC. We know the company will generate enough cash to pay the interest it owes to its creditors. (Remember, the creditors are first in line to get paid. Shareholders could see their cash dividend disappear). We buy ABC's bonds for $800 per bond. That 8% interest on the original value must be paid. Since we bought the bonds for $800, our $80 in annual interest payments gives us a nice yield of 10% per year. Now come the capital gains… ABC has to pay off all of the $5 million it borrowed in two years (remember, the bonds were issued three years ago). It is contractually obligated to pay $1,000 to the holder of each bond. Since we took advantage of the pessimism toward ABC and did a thorough analysis of its ability to pay its debt, we are rewarded with a 20% gain on our original purchase price. We paid $800 for the bond, earned $80 in interest each year for two years ($160 total interest), and we make a capital gain of $200! Here's how the math works out: Bought ABC bond for $800. Collected $160 in interest payments. Received $1,000 when ABC paid off the total debt. We make $360 off our investment of $800 (a 45% gain) in two years. How We Know It's Safe The biggest key to making these big, certain, on-time gains is my ability to perform a solid credit analysis of each and every position. Our bonds must be safe. With all our recommendations, we know the bonds are safe because my analysis says the borrower has adequate resources to pay us. I ensure the company has sufficient assets to pay off our bonds even if it should fall into bankruptcy and be liquidated. That's my job. You see, bonds become deeply discounted because of credit downgrades. A credit agency like Moody's or Standard & Poor's has analyzed the borrower and lowered its opinion of the company's credit quality. Downgraded bonds decline in price because the risk of a borrower default is higher. However, I will not buy a bond unless I am satisfied the borrower has enough resources to pay the interest on the bond and redeem it at maturity. And frankly, most of these bonds are now safe because they have already declined in price. The only reason for a significant further price decline is a default. And, as I said, the value of the borrower's assets in liquidation is enough to pay us. I look for complete coverage of the face value of the bond. This means we have an excellent possibility of not only recovering our investment but of receiving the full value of the bond. Safe, high-yield bonds… that's the core of our strategy. Why would you ever buy stocks...

Bond Definitions Bond A bond is a long-term loan to the government, a municipality, a corporation, or even an individual. The terms of the loan are contained in an agreement between the borrower and the bond trustee, who represents the interests of the bondholders. Bond Trustee An independent third party selected by the borrower to handle bookkeeping on a bond. The trustee represents the interests of the bondholders. Note A note is a medium-term loan to the government, a municipality, or a corporation. The terms of the loan are contained in an agreement between the borrower and the note trustee, who represents the interests of the noteholders. (Also called a bond.) Debt Instrument Debt instrument is the general term used to describe both a note and a bond. Fixed-Income Bonds and notes pay a specified amount of interest. The dollar amount of the interest payments is fixed and does not change for the life of the loan. Bonds and notes are therefore called fixed-income investments. Issuer The issuer is the name of the borrower. Principal Principal is the amount of each bond or note. It is the amount of the loan. Principal, par value, and face value are interchangeable terms. Par Value Par value is the denomination of the note or bond. It is the original amount of the loan. Generally, it is $1,000. Face Value Face value is the same as par value. It is the denomination amount of the note or bond. Generally, it is $1,000. Coupon Coupon is the specified amount of interest on the bond. It is fixed for the term of the loan. Maturity Date Maturity date is the date the bond will be repaid in full. Accrued Interest Accrued interest is the amount of interest that has been earned on the bond since the last payment date. Interest is earned every day, but only paid twice a year. So the accrued interest amount increases every day until it is paid. Interest Rate Interest rate is the cost of the loan to the borrower. The coupon and interest rate are the same. It does not change for the term of the loan. Yield Yield is the relationship between the coupon of the bond and its current price. The coupon does not change, but the price of the bond does. The yield changes as the price of the bond changes. If the bond price declines, the yield increases, and vice versa. Yield to Maturity Yield to maturity is the amount we earn on a bond every year until it is paid. This takes into account the interest paid and the discount or premium of the bond price to its par value. Municipal Bonds Municipal bonds are loans to a municipality. The loan is usually to establish or improve facilities or services that benefit residents. The bondholder does not have to pay tax on the interest payments. Therefore, the interest rates on municipal bonds are generally lower than on corporate bonds. Corporate Bonds Corporate bonds are loans made to corporations. Unless the bonds are held in a tax-exempt account (like an IRA), bondholders pay taxes on the interest. Credit Rating A credit rating is a report issued by a credit rating agency – like Moody's or Standard and Poor's. It estimates the chances of default. Credit ratings are important because they determine the interest rate the borrower has to pay. The higher the chance of default, the higher the interest rate. High-Yield Bonds High-yield bonds are a part of the corporate bond markets. Issuers in this market are more likely to default and therefore, pay more to borrow. Junk Bonds Junk bonds is a nickname for high-yield bonds. Call Call is a prepayment right given to the borrower by the bondholders. The borrower may "call" the bond for early repayment at a specified date, the call date, and for a specified amount, usually at a premium to the par value. Basis Point Basis point is one hundredth of one percent. There are 100 basis points in each 1%. The differences in bonds are often quoted in basis points. For example, an investment-grade bond pays 60 basis points (0.6%) less than a non-investment grade bond. Default Default occurs when the borrower cannot make either principal or interest payments as agreed. The borrower is in violation of the loan agreement and may be forced into bankruptcy.

What is a bond? A bond is a loan. There are three kinds: short, medium, and long term. A short-term loan of less than two years is called a "bill." A loan for two to five years is called a "note." All loans for a longer term are called bonds. Despite these technical distinctions, people often use these terms interchangeably. We will not be investing in bills. So for convenience, I will use the term bond for both notes and bonds. In addition, three different types of borrowers use bonds: governments, municipalities, and corporations. We will be making loans to corporations. A key difference between stocks and bonds is that stocks make no promises about dividends or returns. The company is under no obligation to pay you. However, when a company issues a bond, it guarantees it will pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity (when the loan expires), you know exactly how much you're going to get back. Bonds are traded in $1,000 increments. So for each bond you buy, you'll receive $1,000 at maturity. When we make a loan we want to know four things: 1) What is the amount of the loan? 2) Who is the borrower? 3) How much interest do we earn? 4) When do we get paid? Let's use the Goodyear Tire and Rubber 7.86% bond due 8/15/2011 to illustrate how this works. You decide the answer to the first question. You decide how much money you want to loan. The "face value" of each bond is $1,000. But that's generally not what you pay for our bonds. For example, if the Goodyear bond was selling for $740, and you wanted to invest $10,000, you would buy 13 bonds ($10,000/$740). The next three are answered in the description of the bond. Goodyear (borrower) 7.86% (coupon) Note due 8/15/2011 (repayment date): Goodyear Tire and Rubber Company is the borrower. That's easy. The next question – how much interest do we earn – is a little tougher. The "coupon" is 7.86%. This is the interest the borrower pays on the loan... But it's not necessarily the interest you earn. The borrower calculates the interest payment by multiplying the coupon (7.86%) times the par value ($1,000)... So 7.86% times $1,000 equals $78.60. This is the annual interest amount paid in two equal installments of $39.20 on February 15 and August 15. The coupon will not change. Bondholders are guaranteed payments equaling $78.60 a year per bond. But the price of the bond can change. Here's what it looks like for the Goodyear bond: Current price of the bond $740.00 Annual interest payments $78.60 Yield (7.86%/$740) 10.6% So if you held $740 for this bond, you would receive an 10.6% yield – much higher than the original coupon. The last part of the bond description is the maturity date. This is the date the loan will be repaid. The borrower borrowed $1,000 and will repay $1,000. So you will receive a $1,000 for each bond you hold. What is my return? When you buy a bond, you will get the interest payments, plus you'll be repaid the full amount of the bond at the end of the loan. Your return is the combination of the interest payments plus the capital gain amount. Ideally, you want to be buying bonds at a discount to par value. So when the bond matures, you will have a capital gain equal to the amount of the discount. In the case of the Goodyear bond, the purchase price was $740 and the amount repaid is $1,000. Your capital gain would be $260, or 35.1%. And your interest would be $78.60, or 10.6%, a year until the bond matures. When will I get paid? Most corporate bonds pay interest twice a year. The borrower pays interest to the bond trustee, who sends the interest payments to you. The bond trustee will be an independent company – selected by the borrower – that takes care of bookkeeping. Do I have to pay taxes on the interest? Yes. Unlike municipal bonds, which are exempt from federal (and sometimes state) taxes, corporate bonds pay taxable interest to bondholders. You can get around this by holding the bonds in a tax-exempt retirement account (like an IRA). What are the risks? A bond manager faces many risks: Interest-rate risk, event risk, default risk, credit risk, downgrade risk, prepayment risk, duration risk, and more. We don't have to worry about most of these if we buy debt that's already been downgraded. And if we hold these bonds until they mature, we eliminate interest-rate risk, duration risk, and prepayment risk. In fact, we face only two risks (and they are related)... credit risk and default risk. If the borrower's credit deteriorates, we face the prospect of a default. If the borrower defaults, we may lose all or part of our capital. How do I buy a bond? There is no central place or exchange for bond trading, as there is for publicly traded stocks. Bonds are traded through bond dealers, more specifically, the bond trading desks of major investment dealers, like Goldman Sachs. These dealers buy and sell huge volumes of bonds. They know all about a particular bond and are prepared to quote a price to buy or to sell. When you want to buy a bond, you call your broker, and he calls one of the dealers to arrange the trade. You need to give your broker this information about the bond you want to buy: • How many bonds • The name of the borrower, the coupon, and the maturity date • The CUSIP number A CUSIP is a unique nine-digit code assigned by Standard and Poor's to every traded security. Your broker will arrange the trade, and credit the bonds to your account. Bonds are "book traded," which means your ownership is accounted for and maintained by the bond trustee, an independent company – selected by the borrower – that takes care of bookkeeping. A certificate is not issued.