Options

Winning with Options

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Winning with Options
The Smart Way to Manage Portfolio Risk and Maximize Profit

Michael C. Thomsett

American Management Association
New York • Atlanta • Brussels • Chicago • Mexico City • San Francisco Shanghai • Tokyo • Toronto • Washington, D.C.

Special discounts on bulk quantities of AMACOM books are available tocorporations, professional associations, and other organizations. For details, contact Special Sales Department, AMACOM, a division of American Management Association, 1601 Broadway, New York, NY 10019. Tel: 212-903-8316. Fax: 212-903-8083. E-mail: specialsls@amanet.org Website: www.amacombooks.org/go/specialsales To view all AMACOM titles go to: www.amacombooks.org This publication is designed toprovide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

Library of Congress Cataloging-in-Publication Data Thomsett,Michael C. Winning with options : the smart way to manage portfolio risk and maximize profit / Michael C. Thomsett. p. cm. Includes index. ISBN 978-0-8144-0033-3 (pbk.) 1. Stock options. 2. Options (Finance) 3. Portfolio management. I. Title. HG6042.T466 2008 332.63 2283—dc22 2007039114

2008 Michael Thomsett. All rights reserved. Printed in the United States of America. This publication may notbe reproduced, stored in a retrieval system, or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of AMACOM, a division of American Management Association, 1601 Broadway, New York, NY 10019. Printing number 10 9 8 7 6 5 4 3 2 1

CONTENTS
Introduction Portfolio ManagementAlternatives Chapter 1 A Few Basics Chapter 2 Setting Portfolio and Risk Goals Chapter 3 The Strange World of Options Lingo Chapter 4 A Primer on Options Trading Chapter 5 Spreads and Straddles Chapter 6 The Contingent Purchase Plan Chapter 7 Options for Short-Term Profits Chapter 8 Tax Rules for Options Chapter 9 Diversifying by Strategy Instead of by Stock
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1 5 34 55 79 109 131 153 177 192

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Chapter 10 A Long-Term Portfolio Planning Guide Glossary Index

217 237 245

Winning with Options

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I N T R O D U C T I O N

PORTFOLIO MANAGEMENT ALTERNAT IVES
‘‘Civilization and profits go hand in hand.’’ —Calvin Coolidge, November 27, 1920

M

ost investors face a series of dilemmas in the course of

managing their portfolio. When astock’s value rises, do you sell and take your profit? When value falls, do you cut your losses? Or do you ignore short-term price gyrations and hold for the long term? No one solution is right for everyone. But if you want to hold stocks over a period of many months or even years, there are ways you can take profits or protect against downside movement without selling stock. The solution involvesthe smart and safe use of options—intangible rights attached to specific stocks. Options are complex financial instruments. They are intangible, have a limited lifetime, and are confusing as the result of the industry’s own specialized lingo. All of this can be troubling if you do not thoroughly understand how options can be used.
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Winning with Options

Options are often viewed asappropriate only for individuals who are willing to assume extraordinary risks. The truth is quite different, however: • Options can be high-risk, but they can also be exceptionally conservative, depending on which strategies you use. Properly used, options can provide you with current income and very little market risk, even if you are a long-term ‘‘hold’’ investor. When you want to buy options, you...