If you want to learn about options, you can’t go wrong picking up a copy of The Rookie’s Guide to Options by Mark Wolfinger. It was a little harder to do a review of this book because I’m not an options trader, I’m not terribly interested in options, and I’ve never even opened a book about options outside of Brian Overby’s The Options Playbook for a review a while back.

Overall, the book is really comprehensive and after the first chapter, where the most basic of basics are explained, I felt like I knew enough about options to be a danger to myself. Call options, put options, wonderful… how hard could it be? If it were that easy, there wouldn’t be another two hundred pages to read!

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This is a guest post written by Mark Wolfinger of the investing blog Options for Rookies. Mark grew up in Brooklyn and in an earlier life, earned a PhD (chemistry) from Northwestern. After several years as a research chemist, in Dec 1976 he moved to Chicago to trade options. Over the next 23 years, he was primarily a CBOE market maker, but also worked as a risk manager, and coached new traders. He left the CBOE in 2000 and began a career as an educator. He’s published three books and numerous magazine articles.

Mark recently authored The Rookie’s Guide to Options and he approached me with a novel guest post idea. You don’t normally associate options with passive investing but he is going to explain how you can use options, specifically collars, to protect yourself when passive investing.

Let’s begin by agreeing:

• a) Passive investing beats active investing – for all but the few talented traders who consistently outperform the markets. Let’s also agree that none of us is a member of that elite group.
• b) The rules: allocate assets, diversify, buy and hold, don’t panic by selling into market declines etc. These are the most commonly used methods to minimize investment risk. They are constantly repeated by journalists, bloggers, brokers, financial planners and financial advisors.

Should most of us follow this advice with confidence? Do we save a portion of each paycheck, invest passively, and confidently accept whatever happens?

I vote ‘no.’

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My wife has a whole mess of underwater options with her company, issued before the economy took a nosedive, and was looking to see what her options (ha ha) were. She’ll be leaving her company in early July, to pursue graduate school in her field, and so she’ll only have sixty days after her last day to exercise the options. For the shares that are profitable, it’s a no brainer: exercise and sell. But what can she do with the rest?

She searched the internet for advice on what she could do, fully anticipating the answer was “nothing.” Then she stumbled onto a site that said she could exercise them and use the loss to offset some tax gains. She didn’t understand why that made any sense and so she asked me. I didn’t know why that made any sense either. Since she didn’t remember where she read it, we can’t be sure the advice was serious.

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These brokers are excellent for stock equity trades as well!

As you may have read in my review of The Options Playbook, I’ve started to get interested in trading stock options. As has been the case with everything I try, I do a lot of research first and then I dive right in. As my dad always said, you learn in the classroom or you learn on the street. Learning on the street is always more expensive. I prefer the classroom.

In my limited knowledge of options, it appears that there are two main discriminators: price and tools. For price, it’s a matter of comparing the cost per trade and per contract. For tools, it’s having the ability to quickly make complicated trades without having to jump through too many hoops. In my review of the Options Playbook, I talk about two types of “plays.” The more complicated plays involve several “legs,” or options trades, that hedge each other and the better options brokers let you setup those plays with one screen. In fact, most brokers make that transaction easy because it results in more trades, which means more profit, so it’s almost not even worth comparing brokers based on that (remember, I’m a total novice in this so I may be wrong).

So, it may just come down to price.

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Stock options is something that has always both intrigued me and confused me.

Fortunately, I’ve become friends with some people over at TradeKing and one of them sent me a copy of The Option’s Playbook, written by their Senior Options Analyst Brian Overby . It’s a print version of their entire options education center, available to registered users of TradeKing (sign up for free by clicking here).

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$2.95 a trade.

That’s how much it’ll cost you to make a trade at OptionsHouse.

That’s pretty cheap. TradeKing is currently my go-to broker and they charge $4.95 a trade, 67% more than OptionsHouse. Zecco, which is free if you meet their stringent requirements, is the only one that’s cheaper and they can never seem to get their customer service issues resolved.

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I’ve been using TradeKing for a while now and one of the many things that separates them from their competition (E*Trade, Zecco, etc.) is the wealth of information they offer you, especially with options education. TradeKing has a free ebook, they call them “intelligence reports,” about taxes and the stock market. The Tax & Trading Intelligence Report is free and it’s a seven page document that discusses a variety of stock investing topics from retirement accounts to wash sales.

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My wife works in a management position at a local biotech startup and in that role she’s granted non-qualified stock options from time to time. I wrote about pre-IPO stock options over two years ago but since then she’s received “post-IPO” non-qualified stock options. Since it’s getting to be the end of the year, I’m doing some research as to how the capital gains works and it turns out that stock options are pretty easy to understand.

First, there are incentive stock options and non-qualified stock options. There are several differences but the one that really matters is how they are taxed. This article will focus on non-qualified stock options, non-qualified referring to how they are not qualified for special treatment (incentive stock options are treated differently).

How my wife’s stock options work is that she’s awarded X shares, say 1000 shares, at a grant price, say $10.00, on a certain day. The shares vest over a number of years, say 4 years. So next year she gets 250 shares at $10, the year after she gets another 250 shares at $10, etc. She currently has the options but she can’t exercise them until they vest. That’s the basic vocabulary.

How are these taxed? When you exercise the option, 250 shares at $10, you are immediately taxed on the difference between the market price and your exercise price ($10). If the market price is $12 when you exercise, then you will immediately be taxed on $500 ($2 x 250 shares) of capital gains. You can hold the shares, you can sell them, but you are already on the hook for $500 of capital gains. From there on for tax purposes, it’s as if you bought the shares at $12.

When Should You Exercise Your Options?

So I had this chat with my wife and the first thing she thought of was to exercise the stock options when the stock is at its lowest value. On the face of it, it seems to make sense. The smaller the difference between your grant price and the market price, the less you are taxed. However, you earn less too. It doesn’t matter which tax bracket you are in, you are taxed less than what you earn. In the highest tax bracket of 35%, you keep 65 cents on the dollar; you want the price to be as high as possible before you exercise. The key is to maximize income, not minimize tax.

In reality, you balance your need for the money with the market price of the stock. You always want to exercise at the highest price possible but you have to balance that with whether you need the money or when the options expire. When you exercise, you want to sell immediately. There is no benefit to holding onto the shares. If you wanted the shares in the first place, you could’ve bought them on the open market. By keeping your shares, you run the risk of being taxed on income you will never realize.

This is all based on my own web research, I’m not a tax professional so please consult with a tax accountant or attorney before making any decisions.

I’m not an investing guru, I dispense no professional advice, and the only investing training I have is from the University of Google where classes are available 24/7. That being said, I recently had a chat with my girlfriend who was being compensated, in addition to salary, in the form of pre-IPO shares in the company she’s currently working for. Having little to no understanding of the terminology of options, let along pre-IPO stock options, I had to seek an education.

Here’s how it works, you get hired and they give you a option grant – a document that says how many shares you can buy and for how much. The strike price is the price at which you can purchase the shares. The grant date is the date you officially begin vesting and should be on that option grant sheet.

Capital Gains

You have two dates to remember, the grant date and the exercise date. The exercise date is the date you purchase the shares from your option.

If you sell your shares within two years of your grant date or one year of your exercise date, it is called a disqualifying disposition and your earnings will be treated as income. If you sell within one year of your exercise date, it will be considered short term capital gains – taxed at your marginal tax rate.

Lockup Expiration & Blackout Periods

A lockup is a period of time after an initial public offering when pre-IPO shares can’t be sold; check how long you’ll have to wait after the IPO before you can sell your shares. A blackout period is a period of time, usually around earnings announcements and the like, where you can’t trade your shares either. There is an SEC mandated 3 day waiting rule for trading after announcements too.

Okay, now the vocabulary lesson is over…

Evaluating How Rich You’ll Be

You are not rich. Options are worth nothing in an IPO, just ask all the dreamers from the dotcom era, but they have potential to earn something. How can you figure this out? You really can’t unless you have a crystal ball but if you just ballpark how companies in your industry are faring, how you compare to them, you might be able to ballpark a share price if you know how many shares your company plans on IPO’ing with.

Get everything in writing

This is sage advice for everything. Make sure that option grant explains everything, the schedule your shares vest, what happens in a buyout, etc. because while the intentions might be good when the company is performing well, people can get real ugly when the ish hits the fan.

Remember the old adage, “a bird in the hand is worth two in the bush.”