On Tuesday 11 April 2017 one of my Value Stock Picks: AmTrust Financial Services (AFSI) dropped from $18.87 down to as low as $13.65 then closed at $15.30. The catalyst was a Wall Street Journal Article titled “Secret Recordings Play Role in SEC Probe of Insurer AmTrust”.
AmTrust Financial Services has been on the rocks anyway after advising that financial statements dating back to 2014 were not to be trusted.
About half of the selloff occurred pre-market
The initial panic selling in these instances is often overdone.
Using Stock Options to Manage Risk
With the implied volatility of the stock so high I decided to sell a vertical bull put spread around noon eastern time. The vertical bull put spread is an option position that makes money if the stock is above a certain price (in my case $12.80) when the options expire.
I sold a 15 put and bought the 10 put with a September expiration. Total credit was $220.
By mid-morning on the 12th AFSI had rallied back to around $16.
On paper I had already made some money on the vertical put spread. I decided to sell the 17.5 September call for $200 in credit. I did this for downside protection. This created a half strangle/half iron condor.
Just looking at the options, my break even point on the downside is $10.81 and on the upside it is $21.74. The option market seems to think there is a greater chance of AFSI going back down as opposed to rising. Currently my position is fairly centered. If AFSI does sell off and start to approach my downside break even I will roll down the call I sold.
My maximum gain is $420 if the stock is trading between $15.06 and $17.40 at expiration in September. I will look to close out this position if I get to 50% of that profit.
I’m currently long 25 shares of AFSI. If I didn’t have the option position and the stock dropped down to say $10, I would be at a paper loss of about $211. With the options the loss at a stock price of $10 would be $160. So by adding options to my stock position I’m limiting my losses and also increasing my potential gains if the stock settles down between $10.81 and $21.74 and volatility drops.
The main risk I have, is if the stock were to really take off above $21.74 before September, I would start realizing losses on the option position, whereas if I was simply long the stock I would be sitting on gains.
Given the large drop and the negative press I think this is unlikely. The September 17.5 call also indicates this is unlikely, with a 25% chance of AFIS being above $19.51 in September. Furthermore, if AFSI would to start to go up significantly, I would anticipate implied volatility dropping and I would probably be able to close out the short call at a small loss or perhaps even a gain.
My overall gain/loss looks as follows.
Obviously using options like this isn’t for the feint of heart. Options used emotionally and incorrectly are a great way to loose lots of money fast.
But in this case I’m actually limiting my risk and increasing safety. If AFSI sells off I reduce my downside risk, if volatility drops and AFSI stays rangebound I make money. The main risk is if AFSI takes off again before September and trades above $22.79. In this case I start to lose money. Based on the option probabilities and recent history I judge this to be an unlikely scenario.
AmTrust Financial has issued a statement essentially denying the Wall Street Journal article’s claims and while I am waiting to hear more this selloff could represent a buying opportunity.
As always this is not investment advice. I’m not advising or recommending anyone buy or sell any security, stock or option. I’m simply sharing what I am doing.
I’ve decided to pivot towards a more passive option approach with covered calls.
The reason is twofold. First, I haven’t done well with options (except for August) because of mistakes I’ve made.
Back in November, after the surprise election of Donald Trump and the ensuing stock market melt-up, my option positions blew up and I lost around $1,500. My account size at the time had been around $10,000 so that is a big, big percentage loss over a short period of time.
The second reason is I don’t have free time during trading hours.
Reason One: I Made Mistakes
It should not have mattered much when the markets moved a lot. I pay to follow Kirk DuPlesis’s trades over at OptionAlpha.com. Kirk was only down around 2%. I was down around 15% even though I was in very similar positions.
Why the difference?
The main mistake I made is that I only had about $100 in free margin, which is a big no-no. I should have had $5,000 in margin available. Because I only had $100 when the markets went crazy I didn’t have any dry powder to make adjustments add additional positions to balance out the portfolio or hold positions to expiration.
Kirk was using around 50% of his available margin, so he is able to hold positions to expiration, make adjustments, sell additional premium, and keep his portfolio diversified.
It’s frustrating because while I know the rules I wasn’t following them.
Follow the Rules to Be Successful
To be successful trading options long-term there are several inviolable rules: small position sizes (1-5% of the portfolio per trade), only use half of your available capital, and place a lot of trades so the probabilities work out.
There are other factors too, like using the correct strategy, making high probability trades and being on the right side of volatility, among others.
But I don’t follow the rules! I’m afraid of missing out on a trade, or I allow myself to make an exception “just this once”, or I get greedy. And it burns me every time!
So I’m putting myself in time-out.
I’m going to stop trading options for a while. I haven’t had the discipline to follow the rules that must be followed in order for the math work out in my favor and be successful.
Reason Two: I Have Less Time
Not only that but I don’t have the free time I did when I was seeking out a new, full-time career.
Even though it might be possible to trade options and work a full time job it’s hard. One is confined to placing limit GTC orders before or after work or trading over lunch. However, a lot of the market movement tends to happen in the 30 minutes after the market opens and 30 minutes before the markets close.
When I was doing a lot of trading (July-September) I didn’t have a day job. I had this website, option trading, and selling coins. I set my own schedule.
Now I’m on the road or in appointments 8-9 hours a day during trading hours and I rarely have time to place 3-4 trades 30 minutes before the markets close. I don’t have time to make the appropriate adjustments to existing positions and I don’t have time to look for new trade opportunities.
I need a more passive approach.
So I’m winding down my existing option positions. I’m also increasing holdings in some of my Value Stock Picks and selling some covered calls on them.
Covered calls they work like this: first buy shares of a stock, say 100 shares of Acme Amalgamated for $40/share. Then sell an out of the money (out of the money for a call option contract would be a contract with a strike price above where the underlying stock is currently trading) call contract for a theoretical $100 premium. 10% out of the money would be a $44 strike price.
A call contract legally obligates the call option seller to sell 100 shares of the underlying stock to the option contract buyer at an agreed upon price (the strike price) at any time before the contract expires.
For a more in-depth introduction to covered calls I suggest checking out Investopedia.
With the covered call approach, I sell an out of the money call with a strike price about 10% above where the stock is currently trading, with a contract expiring 30-60 days out, and I buy 100 shares of the underlying stock. This provides some downside protection, regular income (from the option premium) and the only downside versus owning the stock outright is gains are capped at 10% until the contract expires.
With covered calls three things can happen.
1) The stock goes down
In the above example, the stock price could drop as low as $39 at the time of expiration and the position would still break even. Because even though $100 would be lost on the price of the stock (if one were to sell) the call option would expire without being exercised and the $100 premium is still retained.
If the stock fell below $39 a loss would occur, but it would be $100 less than it would otherwise be.
2) The stock goes up or down a small amount, or stays the same price
A $100 profit would be realized plus or minus the gain or loss of the stock. If the stock price was below $44 at expiration the sold call would expire worthless and not be exercised.
3) The stock goes up beyond the strike price
In this case the position would return about 10%. It would be $400 gain plus the $100 option premium. One could either close out the call contract for a wash/loss or just let the position get assigned and the 100 shares of ACME bought for $40 per share would get sold for $44 per share.
So by selling covered calls, you give up some upside potential in exchange for some downside protection and recurring income.
But if I could make 10% every 60 days I’d be thrilled. Lets say the stock is on a tear, and it goes up 15% in the first 30 days and I get assigned, I’d still make 10%. I could then buy the stock back and sell another covered call 10% out of the money, at the end of 30 days the stock goes up another 15%, I would have still make an additional 10%, etc.
I think it is a good strategy if you can execute it correctly. Plus it doesn’t take a lot of time.
Some important elements:
1) Picking a good stock
I want to sell covered calls on stocks (or ETFs) that I want to hold for the long term. I’ve previously talked about what metrics I use for selecting stocks.
Another strategy, for example, is to buy an S&P 500 ETF like SPY and sell covered calls on it.
You need to limit risk and diversify in non-correlated assets. It’s a temptation to buy into the latest hot stock and sell calls on it, or try to use too much leverage on a position. Another temptation could be buying too much stock in a given company or industry.
I would like to go back to trading options in a more active way someday. And I’m not saying I won’t make the occasional earnings trade but if I get back into actively trading options it will require puritanical adherence to the rules.
Below is a summary of the option trades I closed in the month of September.
If you’re not familiar with stock options you might first read my introductory article Get Started Trading Options.
Monthly Trade Summary
September was a tough month. In total I lost $602.03. My win rate was 69% (9 out of 13). I had a total of 19 positions throughout the month: 9 of my trades were profitable, 4 were not, and 6 were “wash” trades. If I gain or lose less than $20 I count it as a wash and don’t use it to calculate my win rate.
My account is about $10,000. Some of my margin usage includes other options trades not listed here because they are made based on the trades placed by Kirk DuPlesis over at OptionAlpha.com and I am not going to post those out of respect for his paid service. I’m also NOT including any profits or losses from the OptionAlpha trades I make.
Again, the trades listed below are MY trades closed out in the month of September.
What I learned from losing $600
You can often learn more from mistakes than successes. It’s easy to Monday morning quarterback with the benefit of hindsight. I like to evaluate my trades based on what I knew at the time and what I reasonably could have foreseen.
I learned/reinforced several valuable lessons. In fact if I had followed the rules I know I need to follow to be successful and I had been more careful that $600 in losses would have been ~$70 in gains.
I want to talk about my three mistakes and the three lessons I learned from each.
Lesson One: Small Position Size
“Bears make money and bulls make money. Pigs get slaughtered.” – Old Wall Street Adage
Novavax (NVAX) Strangles
Notes: My biggest mistake was with NVAX. I made $104 earlier in September but I counted this as a separate position because I completely closed out the previous position and opened this new one.
The reason volatility for NVAX was so high was because the company was awaiting “phase three trial judgment” for a vaccine they were making. The results of the trials were unfavorable and the stock tanked down to around $1.25 from $8.25. In other words the stock lost 80% of it’s value in one day.
I would have been fine if I hadn’t opened the additional 9 8 strangle because it would have been just a ~$300 loss. I got greedy like a pig and paid the price. My account is around 10k, so I should not open a position with a margin requirement over $500 (5%). The initial margin requirement started at $420, but when I opened the 9 8 strangle the margin requirement roughly doubled.
I will cheat up around $100-$150 to open positions in the $600-$650 range because otherwise I wouldn’t be able to open some positions, but when possible, I must keep the position size at or under 5% of the total account value in order to be successful long term, which in my case is $500.
Margin Requirement/Cost: $420 up to $840
Income: -$595.78 (-$582 less commissions and fees)
Lesson Two: Careful Order Entry
ScanSource (SCSC) Earnings Strangle
Notes: This was initially an earnings trade back on August 29. ScanSource missed earnings by a lot and the stock tanked. In after hours post earnings the stock traded down to 37.79, my break even was 37.65. I made an adjustment and held onto the position in hopes of a rebound. The stock did rebound and cut my $330 loss down to around $230.
But then I made a mistake buying the put back for more than I sold it for by entering my limit order incorrectly at the ask price instead of the midpoint. Tough $250 lesson to be more careful particularly in a less liquid market.
Margin Requirement/Cost: $875
Income: -$461.17 (-$449 less commissions and fees)
(VIP) Earnings Strangle
Notes: I opened this up incorrectly! I reversed the call and the put to create an inverted strangle. Closed it out when I could for a small wash loss.
Margin Requirement/Cost: $615
Income: -$18.20 (-$6 less commissions and fees)
Lesson Three: Be on the Correct Side of Volatility
When volatility is low (less than 60%) you want to be a net buyer of options. When volatility is high (over 60%) you want to be a net seller of options.
Adobe (ADBE) Earnings Iron Condor
Notes: This was an earnings trade and I was on the wrong side of volatility. The implied volatility percentile of ADBE was 58%. When selling options you want the implied volatility to be over 60% and the higher the better.
Margin Requirement/Cost: $500
Income: -$126.16 (-$114 less commissions and fees)
Combined these three mistakes cost me $674.36. I expect to lose on some trades and that is okay. For example, I lost on the Verifone earnings trade. But because I was on the correct side of volatility, had the correct position size, and chose a stock with a consistent post earnings volatility drop, I was in a good position to win most of the time. However, these trades listed above are examples in which I could have known not to make and were preventable.
The Rest of My September Trades
Lands’ End (LE) Earnings Strangle
Notes: This was an earnings trade that went according to plan. Closed it out at the at the 50% profit target.
Margin Requirement/Cost: ~$600
Income: $35.72 ($54 less commissions and fees)
Corrections Corp of America (CXW) Straddle
Notes: There was a lot of volatility for this stock when there was an announcement that the department of homeland security was reevaluating using private prisons. A lot of these contracts are at the state level, so I thought the move would be overstated. Closed at 25% profit target once volatility died down.
Margin Requirement/Cost: ~$500
Income: $40.92 ($47 less commissions and fees)
Smith and Wesson Holding Company (SWHC) Earnings Strangle
Notes: Another successful earnings trade. My position size was too big but I was fortunate in that it worked out in this case. Was able to close it out at the 50% profit target
Margin Requirement/Cost: ~$940
Income: $125.80 ($138 less commissions and fees)
Infoblox (BLOX) Earnings Strangle
Notes: Another earnings trade. They announced earnings on August 31. Implied volatility on 2 September had dropped from the 86 percentile down to the 2nd for this stock, but the option pricing didn’t reflect that, IV dropped but was approaching my break even so I just closed for a wash/small loss.
Margin Requirement/Cost: ~$600
Income: -$1.08 ($5 less commissions and fees)
NYMOX (NYMX) Strangle
Notes: There was a lot of volatility for pharmaceutical stocks. Probably related to the EpiPen outrage. Not enough liquidity but was still able to close for a profit.
Margin Requirement/Cost: ~$635
Income: $37.80 ($50 less commissions and fees)
Namtai (NTP) Strangle
Notes: This was another stock trading with high volatility due to an announcement. Not sure how much volatility dropped but time decay certainly helped. Closed at 50% profit target.
Margin Requirement/Cost: Not recorded
Income: $28.92 ($35 less commissions and fees)
Energous Corp (WATT) Earnings Strangle
Notes: Bad Q2 earnings, net short position, high 88th percentile IV, was able to close at a 50% profit target after waiting a little while.
Margin Requirement/Cost: $535
Income: $83.92 ($90 less commissions and fees)
United Natural Foods (UNFI) Earnings Strangle
Notes: I calculated an expected move of +/- 2.77 from 41.80. Didn’t move hardly at all and was able to close the next day for a nice profit. Margin requirement was too high but I didn’t get burned on this one.
Margin Requirement/Cost: $837
Income: $115.92 ($122 less commissions and fees)
Novavax (NVAX) Strangle
Notes: I counted this as a separate from the other NVAX position because these were September options and I closed them completely out before opening a new NVAX position. NVAX was trading with high volatility. Closed this in phases. Added a smaller strangle, which turned out to be ill advised. My initial position had a smaller margin requirement.
Margin Requirement/Cost: ~$650
Income: $104.32 ($147 less commissions and fees)
Aralez Pharmaceuticals (ARLZ) Strangle
Notes: Another pharmaceutical stock trading with high volatility, resumed trading on Thursday 9-15 and was able to close at well over a 25% profit target.
Margin Requirement/Cost: $582
Income: $147.70 ($166 less commissions and fees)
Finisar Corp (FNSR) Earnings Strangle
Notes: Had a big earnings beat, stock went up as high as 26.5 after hours. My break even on the upside was 26.61. Had a very nice drop in implied volatility. But didn’t matter as much since it moved beyond my range. Made some adjustments. Dropped down allowing me to close my original strangle, had a long position on FNSR to make up some of the losses. Closed on the 21st for a wash.
Margin Requirement/Cost: $490
Income: $17.79 ($33 less commissions and fees)
iShares Mexico ETF (EWW) Iron Condor
Notes: Somewhat high volatility, took a neutral position because I think when the fed does not tighten it will help the emerging markets. Perhaps should have gone a little bullish. ETF approached by upper call, so closed out the short call on the 21st. Maybe could of held onto it, but didn’t want the risk.
Margin Requirement/Cost: ~$328
Income: -$1.25 ($14 less commissions and fees)
General Mills (GIS) Earnings Iron Condor
Notes: I prefer the strangle, but did this risk defined iron condor because of the margin requirements and position sizing. Standard earnings trade. Got some implied volatility drop but not as much as the last two earnings sessions. Closed for a wash.
Margin Requirement/Cost: $500
Income: $9.60 ($34 less commissions and fees)
VeriFone Systems (PAY) Earnings Strangle
Notes: Beat earnings but stock tanked beyond my break even. Adjusted the call side down for some additional credit, and hopes that the stock rebounds some. Adjustment ended up costing me more $.
Margin Requirement/Cost: ~$640
Income: -$266.64 (-$242 less commissions and fees)
KB Home (KBH) Earnings Strangle
Notes: Earnings trade. Got a nice drop in volatility but stock was approaching my break even on the high side and decided to close out for other opportunities.
Margin Requirement/Cost: $280
Income: $17.96 ($24 less commissions and fees)
Nike (NKE) Earnings Iron Condor
Notes: Another earnings trade. This one had a nice setup. NKE has a nice volatility drop after earnings, there are month contracts (which have the most volatility “juice”), and IV percentile was at 72%. I’d prefer volatility was higher, but 72% is certainly high enough for an earnings trade. I did a defined risk Iron Condor since the margin requirements are high. Nike announced earnings after hours, they beat, but the stock sold off. As of 10PM in after hours NKE was at 54.09, just hope it holds tomorrow and volatility drops! IV dropped to 28%, and with it the value of the options I sold plummeted. This was a textbook trade, if I could do this 2-3 times a week I’d be thrilled, but unfortunately these types of trades don’t come along every week.
Margin Requirement/Cost: $600
Income: $101.65 ($120 less commissions and fees)
Below is a summary of the option trades I closed in the month of August.
If you’re not familiar with stock options you might first read my introductory article Get Started Trading Options.
My first trade was on the 16th. In total I made $120.87 with a $10,000 account. That is 1.2% over about 2 weeks. However, my option buying power never dropped below around $3,000. So I was using about $7,000 with the rest in cash.
Some of that margin usage includes other options trades not listed here because they are made based on the trades made by Kirk DuPlesis over at OptionAlpha.com and I am not going to post those out of respect for his paid service. I’m also NOT including any profits or losses from the OptionAlpha trades I make.
Again, the trades listed below are MY trades closed out in the month of August.
Urban Outfitters (URBN) Earnings Iron Condor
Notes: Urban Outfitters beat their estimated earnings and the stock gapped up beyond the range I expected it to. I made one good adjustment to limit my losses, but then made a bad adjustment when I sold a 37 strike call for just .16 which added a little more to the loss when the stock moved past 37.
Margin Requirement/Cost: Not recorded
Income: -$56.51 (-$26 less commissions and fees)
Nordstrom (NDSN) Earnings Strangle
Note: The stock stayed in my range the morning after earnings were announced, my profits were initially higher, but I waited and didn’t get out until later in the day, the stock creeped up towards my break even point, and that cut into my gains. Good rule of thumb, close profitable earnings trades out when the markets opens.
Margin Requirement/Cost: Not recorded
Income: $8.92 ($15 less commissions and fees)
Hertz Global Holdings (HTZ) Strangle
Notes: HTZ stock was trading with high volatility. I’m not sure why but I sold some options. Volatility and time to expiration decreased and I made a little money.
Margin Requirement/Cost: ~$750
Income: $18.92 ($25 less commissions and fees)
Big Lots (BIG) Earnings Strangle
Note: My position size was too big on this trade. One strangle would have been more appropriate given my account size. I was fortunate that BIG only beat earnings slightly, and the stock didn’t move too much before I was able to exit for a decent profit.
If I had waited until later in the day to open this position (which I could have known) I would have gotten a better price. If I had waited a little later the next day to close this position (but not too late), I would have made a better profit (not sure I could have known). Plus I was trying to implement the lesson learned in not closing out NSDN asap.
Margin Requirement/Cost: ~$2500
Income: $274.42 ($293 less commissions and fees)
Rigel Pharmaceuticals (RIGL) Straddle
Note: There was a lot of volatility for pharma stocks. Probably related to the epi-pen outrage.
Margin Requirement/Cost: ~$400
Income: $26.92 ($33 less commissions and fees)
Abercrombie & Fitch (ANF) Earnings Strangle
Note: Missed earnings by a lot, moved beyond my range and I lost.
Margin Requirement/Cost: $670
Income: -$262.20 (-$250 less commissions and fees)
St. Jude Hack (STJ) Strangle
Note: St. Jude’s stock price plunged when a large short seller made some unfriendly comments about the security of some of the devices they sell. I opened up a strangle position that would be profitable provided the stock stayed above $60 per share and below $90 per share. The stock opened August 25th around $82, dropped down as low as $74.15, in a rather volatile move.
All else equal options get more expensive when the underlying stock volatility increases, so by selling options during what I thought was an overly volatile move, I’m captured more option premium.
On the 26th St. Jude actually halted trading and made some announcements indicating the claims against them were unfounded. Volatility dropped and the stock regained some value and I was able to close the option position for a profit. I would have liked it if volatility had dropped more, but it was approaching my break even on the upside so I closed it out.
Margin Requirement/Cost: ~$850 jumped to $1,400 after an adjustment, too high for my account size!
Income: $66.30 ($80.00 less commissions and fees)
Designer Shoe Warehouse (DSW) Earnings Strangle
Note: Was waiting for a drop in implied volatility. I think the AAPL 14.5 billion tax hostage situation scared all a lot of stocks down, so even though DSW beat earnings it was down. It rebounded, implied volatility dropped, and I got out for a nice profit.
Margin Requirement/Cost: $610
Income: $43.80 ($56 less commissions and fees)
Margin requirements are rounded to a whole number and are based on the margin requirement when the position was first opened. I’m not very good at noting the exact margin requirement for my position. I just try to keep it around $500. If I made adjustments or margin requirements changed, the number could go up or down.
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.
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.
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.