This is a continuing series on options trading. Part I is here. We’ll be following up with Parts III and VI in the coming days.
We like options because they have the potential to minimize risk and provide leverage. If you buy one hundred shares of a $50 stock (or ETF) outright, you’ve spent $5000. Your upside is unlimited, and your downside is losing $5000 if the stock goes to $0. If stock goes up $1 (2%) you make $100 (2% of investment) and if stock goes down $1 you lose $100. If you short a $50 stock one hundred times you can make $5000 if the stock goes to $0, on the other hand you can lose an unlimited amount if stock goes up. There is the same one-to-one ratio of movement in the stock to profit or loss.
With options, if you think stock is going up, you could buy a Jan 51 call, say for $1. That means that up to January expiration you have the right to buy 100 shares of stock for $51. If you are right and stock goes up to $53 in that time you can sell that call for at least $2. That’s a 100% profit when the stock has only moved 6%. If stock goes down or stays put you lose the $1 you spent. So you’ve risked $1. Similarly if you think stock is going down you can buy a Jan 49 put, let’s say it costs $1 too (puts will usually be skewed up higher than the respective call, but we will discuss that later). If stock goes down $3 you’ve made at least $2 or doubled your investment and if it goes up or stays put you’ve lost a dollar.
Now when you pay $1 for an option you are actually paying $100 since the smallest regular option is for the right to buy or sell 100 shares of stock.
On this site we recommend directional long premium option trading; the main reason for this is that if you were to short a call because you think stock is going down or not going to move or short a put because you think it is going up, than your potential loss if the stock goes against you and you get exercised is unlimited whereas your profit is limited to the premium you received for the option.
This is not to say that many traders and particularly market makers with thousands of option positions don’t make money by selling options and weighing the risk/reward of various scenarios, but being net short options is not something that we will be recommending on this site.
We get a lot of questions about exiting options. Generally, we will sell in-the-money options before expiration to avoid being long or short the stock. If an out-of-the-money option has lost most of its premium before expiration we may hang on to it as a lottery ticket. We wouldn’t get much for selling it and you never know you might get lucky and at the last minute if it comes in-the-money, otherwise it will expire worthless. We might also roll an option to the next month if we think perhaps we misjudged the time-frame for a stock move. So in the above example we might sell the long Jan call or put and buy the respective Feb option. Much of this will also apply to our more complicated option strategies like call spreads, put spreads and butterflies. We tend to unwind them or the parts of them that would cause us to be long or short the stock after expiration. The other fun thing about options is that the implied volatility (which we will discuss later) of the option may also go up. So if you think stock is going to be active and you are right, it may not even have to reach your strike for the premium of your option to go up. For example if you were to buy the Jan 51 option for $1 and stock starts moving more than usual, or people start speculating that it will, then your option may at some point be worth more than $1 even if stock stays below $52 which is where at expiration you would break even.
What options to buy and when is the art to trading and involves weighing likelihood and potential and risk. In the above example, we could have for the same monetary outlay, perhaps bought 5 Jan 59 calls for $.20, spending the same $1. If stock goes up 20% to $60 we will have made 5 times $.80 or $4, thus a 400% profit. A 20% move is far less likely than a 6% move. How much less depends on the volatility of the stock. Our profit potential is significantly higher, but the probability is higher that, even if we are right on direction, that the stock won’t move far enough and we will lose the premium we have paid on the bet. So in every option trade we must consider our conviction level when deciding what month and what strike to buy and how large a monetary outlay we want to make.
(charts courtesy of the OIC and Wikipedia)