Options plays.

Using puts and calls can help you ride out volatile markets

On Thursday, May 13, a series of favorable economic reports and news of takeovers lifted bank stocks. J.P. Morgan (NYSE: JPM), for example, rose $7.625 per share to $146.75, a gain of 5.5% in a single day. The same day, though, other investors in J.P. Morgan gained 183%. How? By investing in options on J.P. Morgan stock.

Welcome to the potentially lucrative but highly complicated world of options trading. There are two basic kinds of options: "calls," which give an investor the right to buy a certain amount of stock and "puts," which give the investor the ability to sell it.

Further, all options have an "exercise" price, also called the "strike" price--the level at which an investor can use his or her right to buy or sell a stock.

The trading volume of options has been steadily rising over the past decade, a testament-to their growing popularity. According to the Chicago Board of Options Exchange (CBOE), trading volume reached a record 406 million options contracts last year, compared with 210 million contracts in 1990.

Trading options can often boil down to a simple speculation: you buy a put or a call in the hope of a quick but sizable gain. Moreover, you can use options to play defense as well as offense. "Buying puts may be considered a form of insurance against the market moving against you," says Tom Rzepski, vice president, derivatives marketing, Nasdaq-Amex Market Group, New York City. "You can protect profits on stocks you're holding."

Consider the J.P. Morgan option described above, specifically, the "May 140 call," which shot up from $3 to $8.50. "May" was the expiration date; options expire on the third Friday of the indicated month so this option would expire on May 21. Option prices quoted in the newspapers have to be multiplied by 100 because each option represents 100 shares. Thus, the "$3" J.P. Morgan option actually cost $300.

The "140" refers to the exercise price, or $140 per share, while the word "call" indicates an option to buy. Thus, the holder of a May 140 call had the option to buy 100 shares of J.P. Morgan stock at $140 per share up until May 21.

Before the merger news broke, nine days before the expiration date, J.P. Morgan was trading at $139.13. In the lingo of the options market, it was "out of the money," or worthless, since investors would not exercise an option to buy shares at $140 when those shares could be acquired for $139.13 on the open market

When J.P. Morgan's stock shot up to $146.75, its option became "in the money," or valuable. Holders of the option could acquire shares worth $146.75 by paying $140. This change in sentiment, from worthless to valuable, powered the option price higher and put profits in the pockets of option traders.

Marty Kearney, senior staff instructor at the Options Institute, the educational arm of the CBOE, notes there are options on about 2,500 stocks, among them AT&T (NYSE: T) and Microsoft (Nasdaq: MSFT). Also, there are options on nearly 70 baskets of stocks, including the Dow Jones industrials and the Nasdaq 100.

If you buy a put or a call, you can't lose more than the amount you pay while you stand to gain handsomely if the stock or index moves in the right direction. On the other hand, selling an option when you don't own the underlying stock exposes you to potentially steep losses. The stock could rise and you'll have to buy back the option at a loss, or else lose your shares to the option holder.

All of these strategies have yet one more factor to consider: trading costs. Using the J.P. Morgan May 140 call example, you might have a sizable $60 (20%) trading profit on the option but have most of the gain wiped out--if your broker charges a $25 minimum commission--on the buy and the sell side. The Options Institutes Kearney recommends trading several options at a time to prevent a broker's commissions from completely eating up your profits.

For more information, contact the Chicago Board of Options Exchange (800-OPTIONS, wwre.cboe.com) or Nasdaq-Amex (800-THE-AMEX, ww.anmex.com).