Originally I had planned on making this a long “Options 101” type of post. I really wanted to spend more time learning the ins-and-outs of trading options before I did this though, so as not to provide bad gouge. But my recent results have been exciting enough that I thought I’d just put pen to paper and start documenting the progress now.
What Are Options?
Options are tradable contracts between two parties which control specific shares/quantities of stock. Think of them as derivatives, almost. The two basic types of options contracts are:
- Puts
- Calls
Each of these types of contracts can be either be bought or sold, just like a regular stock. The difference is that each option contract you buy or sell actually controls at LEAST 100 shares of stock. Sound crazy? Let me explain a little more…
Options fluctuate in value based on many variables. The two most important elements for beginners to remember are the strike price and the expiration date (other than the cost of the option, of course).
Let’s take stock XYZ, currently trading at $50 per share. Maybe we think that by September 1, the stock of XYZ is going to go up above $60 per share. Now, if we had the money to do so, and we were confident enough in this price move, we could just come and outright buy 100 shares of XYZ at $50 per share ($5,000) and when it goes up to $70, we would net a profit of $2000. Not too bad, right?
Well, by buying a call option on the same stock (for example, we buy a September 1 Call Option with a strike price of $60), what we are doing is buying a contract that gives us the right but not the obligation to buy those same 100 shares for the strike price ($60), regardless of how high the stock goes, before the contract expires.
What’s the difference?
It’s all about risk
Instead of risking $5,000 by buying the shares outright and hoping for the best, when we buy the call option, we control those same 100 shares without having to buy them. If the call option cost $1.20 to purchase, then our total risk is essentially only $120 for a controlling stake in those same shares (it’s $120 because each contract is priced per share, but controls 100 shares… so $1.20 x 100 shares = $120).
So what happens if the stock goes above our strike price ($60) by September 1? If this happens, then we have 3 options:
- Do nothing, the contract expires, and we lose our $120. Not smart!
- “Exercise” the call option. We are telling the person who we bought the contract from that we want to buy those 100 shares for $60. If the shares are trading at $70, then we’ve made the same profit as we would have buying the shares outright (minus our trade fee of $120), with substantially less risk.
- Sell the call option. As call options approach and pass their strike prices, the prices of the options increase just like the stock price. It’s not uncommon for the prices of options to rise substantially more, actually.
It’s possible to get several hundred percent gains on an option, for example, even if the stock only appreciated 50%. Each case is a bit unique, and there are many, many other factors at play, but these are the basics.
In order to be right, though, you have to be right about the strike price, the movement of the stock, and the timing.
It’s not easy, but it does carry with it an easy way to control risk.
What about buying a Put option?
Put options function similar to call options except instead of banking on the stock increasing in value, you are hoping it will fall past the strike price. A put option gives you (the buyer) the right but not the obligation to sell those 100 shares of stock for a set price, regardless of the actual price.
Profits are made this way by selling XYZ for its strike price of $40 when the stock has fallen to $20.
Buying vs. Selling
I said before you could buy options or sell them. Buying options (whether puts or calls) carries substantially more controllable risk. If the stock doesn’t behave the way you want it to, all you risk losing is the price you paid for that option. In the example above, only $120.
When you sell an option, be it a put or a call, you are selling a contract that obligates you to sell 100 shares of the stock for a set price. For each of the above options, when you buy an option contract, there is another party on the other end who is selling it to you.
The seller of that option contract is who receives the premium ($120) that you paid for the contract. The seller profits by netting that premium and hoping the price of the stock does not go “In the Money.”
In the money is what it’s called when a stock passes the strike price (moves above the strike price for a call option, or falls below the strike price for a put option). When stocks go “In the Money,” the seller of the option is at risk of being forced to sell his/her shares for the set price.
If you happen to be that seller, that means you will have to sell shares of XYZ, currently trading for $20, to a buyer for $40. Because of this, if the stock price falls to $0 (in the case of a Put contract), or rises to… infinity (in the case of a call contract), your risk is undefined/limitless.
For this reason, selling calls and puts are often known as naked calls and naked puts. I like to think it’s because they’ll make you lose your shirt if you’re wrong.
Many traders who sell options use one of several strategies to manage their risk. Some of these strategies include buying contracts at other strike prices (called vertical spreads), or a multitude of other strategies: Iron Condors, Iron Butterflies, Diagonals, Leaps, etc.
These risk mitigation strategies are beyond the scope of this article, but are great for future reading.
Where to begin?
Selling options yields us an instant profit. We collect the premium that the option contract itself costs. As long as the stock behaves, we get to keep that money. But since I am a value investor, and I’m a big advocate for only doing things for minimal risk and maximum return, then I would advise against selling calls and puts to start out.
I got my start by creating a brokerage account with TD Ameritrade. I didn’t have plans to dive right in, and I wanted to learn more first, though.
Luckily TD Ameritrade offers an incredible trading platform for free called Think or Swim. From what I can tell this is absolutely the industry standard, from beginners to millionaire successful day traders.
The software platform itself has a learning curve all of its own, and is deeply customizable. In fact, it’s so complex that it can be very off-putting to new traders and investors. I was overwhelmed by it when I first started, until I signed up for a few online courses to show me the ropes.
Paper Money, Baby!
But Think or Swim’s brilliance is not in its depth and complexity. No no no… it has an even better use. It allows you to trade with fake money!!! The fake money (or paper money, as they call it) account trades almost in real time with the actual stock market. The prices shown are delayed to prevent exploitation of the platform, but everything else works just like a real, live stock market.
The Paper Money account will let you place an essentially unlimited number of trades, whether you are buying stock or trading options. You can then define and perfect your strategies and find out what works best for you. When you feel like you’re ready to try trading for real, you just switch your account to Live Trading and go at it.
I can’t recommend Think or Swim enough. It is the best tool you can use if you are trying to learn options. Period.
Ok I’ve got Think or Swim, now what?
Once you’ve got the platform installed and are somewhat familiar with it, I suggest you start by simply buying calls and puts. Investigate stocks that you feel are poised for movement in a specific direction and see what you can make work.
Adjust your trading style as you find out what works for you.
As for me, I’m going to post my trades here so you can see how I’m doing and maybe learn from my mistakes as well.
Personally I am tinkering with more advanced options strategies that I mentioned above. Not because I’m an expert (far from it), but because I feel the best way to learn is by doing… as long as it is with controlled risk!!
If you have questions or ideas about options, feel free to post in the comments! My initial experiences with options has been outstanding, and I’d love to learn more about them with like-minded people.
My First Trades
Key:
- BUY: I am buying an option contract or strategy, rather than selling one.
- +1: The number here represents the number of contracts. Remember, each contract controls 100 shares. So if I bought +2 contracts, it would cost double $1.23 ($2.46, or $246).
- “VERTICAL”: This may or may not always be present; it represents the specific strategy I am using for this trade
- 100: This is the number of shares controlled by the purchase
- 16 FEB 18: This is the expiration date of the contract(s). It is the date by which I either need to take action to get profit, or loss.
- 63.5/68: These represent the strike prices of the options I am trading. In this case, I bought a call option with a strike price of $63.50, and then I sold a call option with a strike price of $68.
- The sale of the $68 call netted me a credit which was put towards the price of the $63.50 call. When combined, it lowered the price I paid for the $63.50 call, and ended up with my total cost for this entire trade being $1.23 (or $123)
- LMT ISE [TO OPEN/TO OPEN]: These are instructions to the platform on the price(s) I’m willing to pay for this contract and don’t have quite as much to do with your trading strategy.
BUY +1 VERTICAL QCOM 100 16 FEB 18 63.5/68 CALL @1.23 LMT ISE [TO OPEN/TO OPEN]
This is called a vertical spread. It’s when you buy a call option and then sell another call option at the same time for a higher strike price. The sale of the higher strike call option credits you with the price of that option, and brings down your total cost for the call option you purchased.
The benefit of this strategy is that it lowers the cost of the call option you are buying, and thus limits your risk.
The drawback of this strategy is that it also limits your gains. If the stock price goes both of the strike prices, you max out your profit because since you sold the higher strike call option, any profits from your lower strike option will be offset by your losses from the “in the money” option you sold… if that makes sense.
Basically, with a vertical spread, you want the price of the stock to rise above the strike price of the option you bought, while staying below the price of the option you sold.
I bought this contract on 2/9/2018 for $1.23 and sold it on 2/16/2018 for $1.71 for a profit of $48.
SELL -1 IRON CONDOR GILD 100 16 FEB 18 82/84/73/71 CALL/PUT @.38 LMT ISE [TO OPEN/TO OPEN/TO OPEN/TO OPEN]
Iron condors are strategies used when you expect a stock’s price to stay within a range over time. The maximum profit from this trade is the credit you receive for the sale of the options. The maximum loss is the cost of the trade.
This is a strategy that involves selling a selling a call and a put, and buying a call and a put. The the range in which you profit is the price between the two options that you sold. In this case I wanted the stock to stay between $73 and $82 by expiration. If it behaved, I would pocket the $38 premium I received for the sale.
Since this was a contract that I hoped to have reach expiration within that range, my hope was that it would expire “worthless,” and thus allow me to keep the premium. In this case, the stock closed on Feb 16 around $80 per share, and so it was a winner for $38.
SELL -1 VERTICAL QCOM 100 21 SEP 18 55/50 PUT @1.12 LMT ISE [TO OPEN/TO OPEN]
This is my first attempt at a longer term contract. I have high hopes for QCOM being acquired by a competitor, and am hoping their price remains above $55, so I sold a $55 put option. This would be dangerous by itself because if the stock fell below $55 and then continued to drop to $0, I would lose a substantial amount of money… or undefined risk.
To hedge this bet, I then bought the $50 put. This ensures my losses are limited, because if the stock continues to fall past $50, I will then be making money on that particular option to offset the losses from the $55 one.
With this trade, my profit is capped at $112 if the option expires worthless because that is the credit received for the contract. Before that time I can sell the option itself for a profit as well. As of 2/21/18 this contract is still open.
Conclusion
Well there you have it. My options for dummies guide. Keep in mind, I often consider myself a dummy, and I strongly advise you to do your own research before following my lead into any positions.
I don’t intend for options trading to become a major part of my side hustles scheme but if done smartly they can supplement income in a safe manner over time. If anything, it’s a fun learning experience with a little supplemental cash when there aren’t many value stocks to buy outright.
As always, I welcome discussion, and if you have any questions, please let me know!