2 Easy Trades Even Your Neighbor Could Make

Includes: CBOE, F, SIRI
by: SA Editor Rocco Pendola

I have a neighbor who is big into yoga and loves cats. That's pretty much all I know about her. We were talking the other day and, somehow, options came up. Before we started discussing options, the conversation involved our building's maintenance guy, silver, inflation, the need to invest and the notion that you do not need much money to invest regularly. Most on-the-stoop investing conversations I have, however, do not lead to options talk.

My neighbor knows relatively little about me. Regular Seeking Alpha readers probably know more. All she knows is that I "write" for a living. I found it quite odd that she is not only into investing and watches CNBC all day, but she never misses an episode of the CNBC show devoted to options, Options Action. That's pretty hardcore.

Later I discovered that she actually has Seeking Alpha "bookmarked," but just never came across my work. So humbling. I did not plan on telling her what I do; believe it or not, in person, I tend to be quite shy about such things. But after telling me that she's "obsessed with options," she complained a bit that some of the stuff the traders do on Options Action is way too confusing. She said that "calendar spreads" and "butterflies" are probably not appropriate for beginners or long-term investors such as herself.

That's when I had to point out the irony that I spend most of waking hours with the market and writing for Seeking Alpha. But, it's more specific than that. I place considerable focus on options. And I wrote an options eBook and started a stock option investing newsletter because of people just like my neighbor. Long-term investors who want to make basic use of options for growth, income, hedging and a little speculation.

Let's call what's going on "out there" a meaningful coincidence.

Between the volume of email I receive from readers, the things I read across outlets and this chance options encounter with my neighbor (which I am guessing happens independent of us, around the world, dozens, if not hundreds of times per day), I'm convinced - and have been for a while - that retail investors not only want to know about options, they want to understand how to use them properly.

The available data backs up this theme. Consider this from the Options Industry Council:

Total options trading volume for 2011 came in at 4,562,748,194 contracts, surpassing last year's record by 17.02% when 3,899,068,670 total options contracts were exchanged. Equity options volume was 4,224,604,529 contracts, 17.01% higher than the 3,610,436,931 contracts traded the previous year.

Trading volume in 2011 marks first time volume topped 4 billion contracts in a single year and the ninth consecutive year of annual record volume.

Of course, that's not all retail, but volume has been rising among everyday investors. Two quotes I came across in a November 2011 Bloomberg article, however, only reinforced my conviction that retail often starts on the wrong foot with options:

"Options are kind of like the crack cocaine for brokerage firms," said Andrew Stoltmann, a securities attorney in Chicago. "They're easy money, huge commissions and they tend to be extremely addictive for those who actually trade them."

"Options are at the forefront of brokers and brokerage firms' collective minds," said Stoltmann, the securities attorney. "But I don't think most investors appreciate the true risks of these things. It's like rocket fuel on a fire and people can be wiped out very, very quickly."

And, if you go outside in the rain without an umbrella, you'll likely get wet. Humans love to point out problems, while going light on solutions or, at the very least, considering real reasons why problems exist. I'm as guilty as the next complainer. It's not that I doubt the accuracy of the attorney's statements, it's just that he's Mr. Obvious.

Personally, I think the brokerages and groups like OIC and the Chicago Board Options Exchange ((NASDAQ:CBOE)) have, for the most part, acted quite responsibly in how they market options. Sure, if these groups can get more people to trade options, they make more money, but I do not see them acting recklessly.

It comes down to a simple reality - it's tough for many people to get their heads around even basic options strategies, just like it was for me to master factor analysis and multiple regression. But, when I was doing research, I dove right in and made some mistakes. And that was fine because I learned from them and had very little on the line. That's not the case in stock option trading and investing. If you don't know the difference between a call and a put, you could get "wiped out very, very quickly."

People email me everyday about options. At least once a week, somebody says something like this:

Yeah, I am going to do a call on Apple, but what's the difference between "Buy to Open" and Buy to Close?"

No joke. That's representative of the types of questions I receive on a regular basis. And I'm not poking fun at anybody, but that's just a basic example. I have people emailing me with multi-legged options trades and they're not even set up to trade options with their broker. They did not even know it required approval. You simply cannot get into options trading without knowing all of the basics you need to know, simulating trades for several months and knowing the difference between a "good" trade and "bad" trade.

In this article, I highlight two solid trades your neighbor could pull off, alongside two trades that have something wrong with them.

Sirius XM (NASDAQ:SIRI) reports earnings Thursday morning. Your neighbor has three lifetime subscriptions and a vanity plate on his Tahoe that reads, "LONGSIRI!!!" He listens to CNBC when driving across the country just so he can listen to satellite radio. He wants to complement the 5,000 shares of SIRI he bought in 2006 for $4.25 a share with some calls ahead of earnings.

Your neighbor picks up his CB radio and asks what you think of the SIRI February $2.50 call that he can snag for $0.02 a contract. He ran the numbers on the CBOE Options Calculator and figures that when SIRI runs to $2.60 after earnings, those calls will be worth a cool $0.13. He'll be rich. Here's hoping you refuse to fuel his insanity with a "Long Live SIRI" chant after threatening to murder any short seller, market maker or hedge fund manager who stands in the way of his trade.

That sounds absurd, but close-in, OTM calls that cost a couple to a few cents take in the suckers earnings report after earnings report. Forget about fancy things like implied volatility; just use common sense.

The calls your neighbor should buy if he's bullish - something like the SIRI January 2013 $1.50 contract - cost quite a bit more than $0.02. As of Tuesday's close, they went for about $0.70 to $0.75. There's a simple reason why they cost more. They're more likely to be ITM at expiration than the lottery ticket your friend wants to bet on.

No question - investors get burnt when they make option trades ... misguided ones with low probabilities of success.

Let's explore the same idea a bit more with a stock everybody seems to own long-dated calls on - Ford (NYSE:F). I broke my own rule here. I am almost ashamed to admit it, but sometime last year I bought 10 F January 2013 $20 calls. Think about that for a second. The stock will need to pop more than 52% from where it closed on Tuesday to hit that strike.

Now, I might not need it to hit the strike to profit, but you still have to consider the reality that a stock with F's recent history is unlikely to make such a massive move up. If you really see anything near 50% upside in F within a year, you're likely playing cruel psychological games on yourself. It's a bit like the SIRI syndrome. As with that stock, some folks did really well when F catapulted from $2 to $18. But, just because it did that once, does not mean it will do something even close again.

If you're bullish, pony up for the F January 2013 $10.00 call $3.40. Certainly, that's a bit pricier than the $0.11 the $20 strikes fetch, but, again, there's a reason for that. Yes, the common sense probability thing, but also time decay. It's not a factor right now, but when it becomes one, a few weeks to a few months ahead of expiration, and F has not beat the world, you have all time premium in that OTM call. There's no instrinsic value to hang your hat on like there is in the ITM contract.

If you're going to do anything with that OTM F call, sell it against a position in Ford stock. You'll be taking a sucker's money as opposed to giving yours away. The income from a written call can also help finance the purchase of more sane and logical ITM or ATM contracts.

Disclosure: I am long F.