Do you want to get started trading options?
What are options and how are they useful?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.
Source: http://www.investopedia.com/university/options/option.asp
If that seems like a foreign language don’t worry. I’m going to break down what that means and provide an example to illustrate one way options are very useful.
If you buy a put option you have the right (but not the obligation) to sell a stock at a given price within a given timeframe. The put option seller has the obligation to buy the underlying stock from you at the given strike price, provided it is exercise before the expiration date. The seller gets a premium for providing this “insurance”.
Additionally you can buy what’s known as a call option where you have the right (but not the obligation) to buy the underlying stock at given price within a given timeframe. For the privilege of this “option” you pay a premium. On the other side of this option contract is an option seller who has the obligation to sell you the underlying stock at the strike price at any time before the contract expires if you choose to exercise the option.
Aren’t Options Risky?
I’ve been trading options for around a year now. They can enable an inexperienced trader to lose money fast. However with the right education trading options is a great way to generate active monthly income.
I’d like to use an analogy to explain the risks of trading options.
Say you know how to drive an automatic transmission car in the US. But now you’re in a hilly and busy part of Britain and you’ve got a stick shift car. You’ve never driven a manual transmission car before, you’re not familiar with the area you’re driving and you don’t know the rules of road.
It’s going to be bad. Very bad.
But if you practice driving “stick”, learn the rules of road in Britain (like driving on the left side of the road, etc), don’t take too many risks and learn the area you’ll be driving in, a manual transmission automobile is an excellent and safe way to get around Britain. There are still risks but if you’re careful they will be small and rare.
If trading stocks is like driving an automatic car in one’s home country. Trading options is like driving a manual car in a foreign land.
Trading Options Can be Profitable
Unfortunately I’ve learned this the hard way. I thought, “I’m a smart guy and I’ve been trading stocks for a long time, I’ll jump into options!” As a result I lost a lot of money.
I have been interested in options for a long time and was devoted to finding a way to make money with them.
I believe that I’ve found a trade methodology that is profitable in the long run. In fact in August, making my own option trades, I’ve brought in $120 using an account that is roughly $8,000 in size. That’s a 1.5% gain in just a couple weeks.
I link to a free option education resource that I highly recommend later in this article. I’ll also be sharing the trades I made in August in a different post.
Tell me more about Stock Options!
I’d like to contrast options to stocks, since more people are familiar with stocks.
When buying stocks you want to buy low and sell high. You might also be interested in the dividend the company pays to shareholders. With stocks the name of the game is if the stock goes up or down.
Options are a different animal. Yes, direction matters, but option pricing is also a function of the time to expiration (the given timeframe you have to exercise the option) and implied volatility.
As it pertains to stock options volatility is how much the underlying stock price moves up or down within a given timeframe. For example, a stock that goes down in price 50% and then up in price 100% over a period of two days is more volatile than a stock that goes down 10% and then up in price 20% over a period of two days all else given.
Understanding volatility and how it impacts option pricing is arguably the most important difference between trading stocks and trading options.
Purpose of Options
But why even buy options?
You can use options to speculate (using leverage) on the direction of a stock up or down. You can use options to open or close a long stock position. You can also sell options to gain a premium depending on if you think a stock will go up, down, or sideways. I think of selling options as selling insurance.
Another reason for buying options is to hedge a position. Let’s dive into the example to explain how you can use options to hedge a position.
Let’s say you own a stock you think will go down $16 in value, but you don’t want to sell it (and pay commissions and potentially have a taxable event). You could buy a put option. A put option to protect a stock position is like buying insurance against losses.
An Example
For example lets say you own 100 shares of Apple stock (AAPL). AAPL is currently trading at around $106. Lets also say you think that the September 7 Apple event is going to disappoint and that the stock is going to go down to $90 per share. (This is just an example and should not be construed as my opinion on Apple, next iPhone, or stock movement.)
Lets also say you bought AAPL when it was trading at $50 and you don’t want to sell your stock at this time and have to pay taxes on $50 per share in gains.
Current theoretical AAPL position
Current AAPL value: $106 per share x 100 shares=$10,600
Cost: $50 per share purchase price x 100 shares=$5,000
Unrealized Gain/Loss: $5,600
If AAPL were to drop to $90
New AAPL value: $90 per share x 100 shares =$9,000
New Unrealized Gain/Loss: $4,000
So if you’re right and AAPL does drop to $90 per share you’re going to give up $1,600 in unrealized gains. (Unrealized just means you haven’t sold the stock and realized the profits yet.)
In order to hedge (or insure) your AAPL position you could go out and purchase a put option that expires on 16 September with a strike price of $106. One such option costs as of writing $1.77 and lets you sell up to 100 shares at a price of $106 for a total cost of $177 ($1.77 x 100).
So again lets say you bought the $106 strike price put option for $177 and AAPL does drop down to $90 on 8 September.
You’re gain/loss on the stock would be the same, $4,000. But you’d have the option to exercise your put option and sell AAPL at a price of $106. If you did that you’d keep your AAPL gains, less $177 paid for the put option.
So your gains would be $5,432 once you exercise the option and take into account that you paid $177 for the option.
Now the downside is that if AAPL doesn’t drop down $1.77 you are better off NOT exercising the option and you’d have paid $177 for nothing except peace of mind.
So buying a put option to protect a stock position can be thought of like homeowners insurance. You hope you don’t have to use it, but if your house catches fire and burns down you’re glad you have it.
Now I mentioned before one of the reasons for buying the option to lock in gains was so you wouldn’t have to sell the stock. Exercising the option is one choice but that still creates a taxable event.
If AAPL were to drop down to $90 the intrinsic value of the option would be at least $16 per share. Because the option contracts come in lots of 100 that option would now be worth somewhere around $1,600. In reality the option would likely be worth even more depending on the implied volatility, time decay and a lot of other complex factors beyond the scope of this article.
The point is you could sell the put option for a $1,600 profit, without ever exercising it, and never touch your stock position.
An Excellent Free Resource to help Get Started Trading Options
To learn more about options I highly recommend OptionAlpha.com. OptionAlpha.com is run buy a guy named Kirk DuPlesis. I’ve never met him in person but we’ve exchanged emails and he is a great guy.
Disclaimer: I am not compensated for recommending option education at OptionAlpha.com.
Kirk has created dozens of training videos that are available for FREE.
Not only are the videos 100%, no-catch, FREE, but watching these videos are one the best ways to learn about options and how to trade options.
The OptionAlpha website and podcast have been very valuable resources for me and I’ve paid for some of Kirk’s more advanced information, like his trade alerts and stock watchlist.
I think Kirk is giving away tons of high quality information for free because once you see how much value you get from his free materials, you’ll be very likely to buy some of his other paid services.
Again, I don’t gain anything from Kirk or OptionAlpha.com by recommending you visit his site. It is a valuable resource that I’ve taken advantage of that I want to share with my readers. I wish I had known of OptionAlpha.com to help me get started trading options. It would have saved me a lot of money and allowed me to avoid a lot of mistakes.
Options can be very risky if done incorrectly. Trading and selling options is not right for everyone. If you decide to learn more about options, get educated at places like OptionAlpha.com, paper trade for a long time, and keep your position size small.
I’ll be posting another article later in the week with the option trades I made in the later half of August to make $120 with an $8,000 account. I’m still an option trading neophyte and I don’t recommend anyone trade options without first considering your risk tolerance and investment objectives. Get educated and make your own decision.
I just want to share one of the things I’m doing to grow my wealth.