Tuesday, February 2, 2010

Options trading 101: How to trade stock options

Stock options are very different than regular shares of stocks, so options trading is also going to require a different understanding and different strategy. If you want to buy a stock you will be entitled to hold however many shares you purchase, and those shares are redeamable for anyone who wants to buy it for as long as those shares and the company with it are still around and trading on the stock exchange. However, if you look to buy call stock options, you are basically getting a contract that is limited in how long it's good for and it may only entitle you the right to trade the option contract itself only for as long as the stock option contract is still valid and there is a buyer willing to take on the risks for you to sell it.

This can get confusing. You are actually buying a device that's related to the stock, but trades independently. However, the option contract MAY entitle you to 100 shares of the stock at the given price.

Stock options are the right but not the obligation to own shares of the underlying stock at a fixed price. In existance are also "index options" or even exchange traded funds options, but these function relatively the same way. So if you were to buy a stock in the SPY an etf for the S&P 500 index, you would buy 100 at the current price, say $130 per share for $13,000. What if however, you thought the market was going to move upwards in a short period of time? You could pay $185 to control the movement of the 100 shares. That's not a typo, however your chances of losing all of that $185 is great.
So if your ETF went from $130 to $120 and you owned the stock, you would lose $1000. If it stayed the same you'd break even, if it went to $140 you'd gain $1000.
If instead you owned the option, you'd lose everything if it was at $120. In fact, if it was at $130 and expired you'd lose everything. However, if it went up to $140, your options would be worth $10 per share. A contract for one option contract is worth 100 shares in almost all cases. So that means that your stock would be worth $1000. Note I did not say you would gain $1000. The reason is because this $185 comes out of your cost. If it were to go up overnight, there would still be plenty of time for it to go up more so people might pay you enough for you to make close to $1000. However your upside is reduced significantly. Your cost is significantly less though. There's a trade off. You give up your overall catestrophic loss total as your loss can never be more than the $185 you spend, while maintaining a similar upside. However the probability of you losing your entire $185 is high and if in 1 month you want to own it longer you will have to buy another contract, or buy one that has more time to begin with and just sell it before expiration.

So you're thinking, wow, this is a great way to get rich, I'll just buy $13000 in options instead of stock, and then I'll have close to $130,000 if I hit it big and the stock/ETF goes up from $130 to $140!

Whoa, slow down cowboy! (or cowgirl)... Although your gains are multiplied, you are taking extremly more risk by doing this.

If you want to become accustom to buying options, you will want to buy options with a LOT of time value on them that are deep in the money because they behave more like stocks. What I mean is they have a lower chance of losing everything, and you can own them longer if you have to, and if you sell them early they maintain a lot of their initial value. On the contrary, out of the money contracts with little time value are more like lotto tickets because your chances of hitting it big are less, and your chance of losing it all are great. They may have better return in the long run than lotto tickets, but if you went out and put all your money on a lotto ticket, you better be prepared to lose it all.

A generally sound strategy is to buy stock options with 3 more months on the contract than you plan to hold it, and sell it before then. This is because people generally won't buy options close to expiration. Meanwhile, people that own options tend to try to panic and sell towards the end when there's not enough buyers. So what happens is, People buy contracts with 1-3 month on it. In order to sell you need a buyer. There are plenty of buyers who will buy your option so there is a lot of demand, so there are a lot of dreamers thinking the stock will continue to go up and that they have plenty of time to sell. However, the closer you get to expiration the more people are waking up saying "there's not much time left!" And all those who own options that are expiring are going to want to sell it because they don't want to be forced to buy 100 shares at th given price otherwise they wouldn't own the option. True they can borrow money buy it and then sell it and some brokerage houses will still redeam the options for even value but the mentality remains the same. Picture it like Christmas shopping... There are plenty of buyers in at the last second, but stores don't want to get caught with too much inventory, or else they will have to mark down items significantly afterwards. After the demand drys up, there are no more buyers, and those looking to sell are in trouble. If you wait until the last minute it will be a hectic frenzy, and if there's any major popular items and sales, they will probably be gone. Avoid the herd mentality... Get in and out early. If you plan months in advance you will generally be glad you did, as there will be a lot of dreamers looking for the high percentage that take on too much risk.

Additionally when you are options trading, start very, very small. Absolutely minute and miniscule. Option trading can be very dangerous because they are derrivatives. Gasoline is less stable than oil because it was derived and refined from oil. Fumes of gas are derrived from gasoline and are even more dangerous. If you light a match near oil, you may be okay, gas, it's dangerous, but it's always the fumes of gasoline that catch fire first.

Put options as opposed to call options allow you to bet against stocks similar to shorting stocks. If you understand how to short stocks this will make more sense. You borrow shares of stock and sell them promising to buy them back, ideally at a lower price. Sell high, buy low. If that's the case, then put options are to shorting stocks what call options are to buying stocks. You have the right to sell stock at a certain price. So if you buy a put option at a strike price of $100 and it is currently $110, you need it to fall below $100 before it expires, or else it has no "intrinsic value". If it stays the same it loses value over time. If it drops to $90 your stock options are worth $10 per share or $1000 per contract(a contract is for 100 shares) plus whatever time value or "extrinsic value" is left on it. Extrinsic value is the potential value... what people pay for the dream of hitting it big. Intrinsic is what it can be directly converted to right now. A call stock option costing $3 for a strike price of $100 when the stock is $102 has intrinsic value of $2 and extrinsic value of $1. In reverse a put option costing $3 for a strike price of $100 when the stock is $98 has an intrinsic value of $2 and extrinsic value of $1. The extrinsic value is what makes options so different, and the key strategy should be to minimize the damage from the loss of extrinsic value while still gaining the benefit of the intrinsic value going up significantly leading to large percentage gains with lower expense.

You can perform "covered calls" which are selling calls against stock you own... This allows you to PROFIT from the extrinsic value decay, however in the process you are renting out your stock. So if a stock goes up while you are selling a covered call, you do not gain from the price appreciation past the strike price. You get the cash immediately and can use it, but if you still have a call option sold after expiration and the stock price is above the strike price, your stock gets "called" away at the strike price. So if you have a $104 stock and you sell a strike price call of $105 for $2 per share and it goes up to $110, you MUST sell it for $105 even though at the open market it's worth $105. However, if it stays at $105 or lower, you keep $2 in your pocket, and can choose to sell another covered call on a monthly basis if you like. The idea is that you are trying to profit from the optomism of call buyers and collect income regularly. You may occasionally get your stock called away and have to buy again if you want your income back... It's tricky because you have to actually know what a stock is worth. If you think it should be valued at $105 with a EPS of $3 and no earnings growth or decay, it should be worth $105 this year, $108 next year, then it would be a good idea to write a covered call for $105 or $110. This way if people do bid it up to $110 or higher, you no longer should be concerned because you planned to sell it at that price anyways. If however the stock drops to $80, you could buy more. If you buy it at $105 with a $3 earnings per share appreciation, you will expect to gain roughly 3% per year just owning the stock as the earnings will add to the company, the company will improve and the value will improve and the shareholders will be more willing to pay more. However, if you regularly yield $2 per share every 2 months for selling the covered call 6 times per year, that's $12 plus the $3 or $15 per year per share or almost 15% If you are able to sell at $110 you lock in a nearly 5% gain which is more than you planned on anyways. That is the idea behind covered calls, lock in a selling price and cap your potential upside, but get paid for it from optomists.

I have a lot more to add and clear up but this was an article that I had to completely rewrite since after I lost this blog and had to try to restore it. The explination needs improvement as I had spent a lot more time figuring out how best to explain it before, but ideally it will improve over time.


  1. Trading options definitely involves learning various aspects and strategies. Thanks for sharing your insights!

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  2. I really wanted to learn this whole process of trading stock options. So many of my friends earned a lot by investing their money in stock options. Above explanation gave me an overview about the whole process. Thanks.
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