• Options basics and terminology (this article)
• Simple option transactions and strategies
• How to simulate short selling with options
• How to simulate margin trading with options
• Using options to generate cash
• Using options to reduce risk
• A blend of strategies for Trend Timers

Without further ado, let's begin with options basics and terminology.

What are options? Unlike stock securities which convey ownership or "equity" participation in a company, an option security is a contract that conveys a right to either buy or sell the financial instrument on which it is based at a fixed exercise price, before the expiration date. There are regular options that have expiration dates of up to 9 months after they are issued and there are long-term options called LEAPS with expiration dates of up to three years. Options are also frequently described as derivative securities because their value is at least in part derived from the value of the underlying security. In the U.S., options are regulated by the Securities and Exchange Commission (SEC) and all options and all exchanges work though the Options Clearing Corporation (OCC). There are many different styles of exchange-listed options around the world but the only ones we will concern ourselves with are the so-called standardized "American-style" traded on U.S. exchanges.

Underlying security. For our purposes the security on which an equity option is based can be an individual stock, ETF, or even a market index. There are option-type contracts for just about anything under the sun, such as commodities, but these are generally based on futures and are not pertinent to our option investment activities.

Two option types. The two standard equity option types are calls and puts. A call option contract conveys to its owner the right (not the obligation) to buy 100 shares of the underlying equity, at a set price per share (the "exercise price" or "strike price"), for a predetermined amount of time, no later than the expiration date. The buyer, or holder, of the call could be betting that before time expires, the shares of the underlying will be worth more than the strike price of the call option, but as you will discover, the motivations for an investor to either purchase or write an option can be many. Conversely a put conveys the right to sell 100 shares of the underlying, at a set price per share, for a predetermined amount of time. You buy an option contract from two types of sellers: either a person that bought an option in the past and now wants to close out that position, or a person who chooses to create, or write it. Where the buyer of the option has a right to exercise, the writer of the option has the obligation to fulfill its terms if called upon to do so.

Long and short positions. In options terminology the words long and short have a very different meaning than with equities. If you buy and own an option, call or put, you are said to be long the contract. It does not mean you have a bullish market position. With options, the word short means that you have written a call or put option, that you are short that contract and have the obligation to fulfill its terms if you are assigned an exercise notice.

Sell, exercise, or expire. When you are long an option contract (you bought it and you own it), you have the right to either exercise the option (by buying the underlying shares if a call, or selling the underlying shares if a put), sell the option in the open marketplace (if it has value and there is a bid price to buy the option), or to let it expire unexercised.

Why use options? There are generally three objectives for contemplating the use of options investment strategies: portfolio protection, income generation, and speculation/leverage. The driving force for Trend Timers is primarily as an alternative to bull/bear mutual funds in retirement accounts. As it turns out, the strategies we developed specifically to work with the TimingCube strategies can combine all three objectives of options.

Requirements:

• Know exactly what you are doing and getting into or do not touch options with a ten foot pole. We think very highly of our Trend Timing School articles but they by themselves do not constitute complete or sufficient education. See the Additional Resources section below for good educational sources
• Options account. You generally need to get your broker to approve options trading in your account(s) by submitting an Options Request Form, or one by a similar name. The good news is that this can be done in just about any regular or qualified retirement account
• Keeping your head on your shoulders and your feet on the ground. Options are very versatile and sophisticated securities which could be used to create extreme risk where one not only stands to lose the entire invested capital but more
• Stay on top of your options. Unlike the "buy and forget" (until the next signal) ETF or mutual fund investing we normally do, options require attention and management. For example, if you let the expiration date sneak up on you, the contract will expire unexercised and worthless.

Additional resources: As we said at the beginning, the best course of action is education. If you are not able or willing to invest sufficient time and effort on education we respectfully suggest that you stay away from options altogether, or use a professional. As registered investment advisors our colleagues at MARKETTREND ADVISORS can implement options strategies in managed accounts for you. If you prefer the self-education route, here are good places to start.

• The Options Clearing Corporation (OCC) (http://www.optionsclearing.com) - the source for the must-read "Characteristics and Risks of Standardized Options" (http://www.optionsclearing.com/publications/risks/riskstoc.pdf)
• The Options Institute - education by the CBOE (Chicago Board of Options Exchange) (http://www.cboe.com/LearnCenter/cboeeducation/indexoe.html )
• The Options Industry Council (http://oic.theocc.com) - a non-profit association created to educate the investing public and brokers about the benefits and risks of exchange-traded options
• Investopedia.com - A source for most everything in investing
  

Warm wishes and until next week.

The TimingCube Staff