I’ve always been fascinated with options. Not because of the potential of a large payout, but just the structure of them. I don’t believe in the big payday hype, and neither should you. For 99.9 percent of options traders, trading with such strategies will surely destroy your bankroll. Developing such risky tactics (such as naked calls, which we will explain over the course of this blog) can make you a ton of money, but can also cripple your finances.
So Exactly What is an option?
You probably wouldn’t believe me if I told you that you already know what an option is, but you do. You use them multiple times in your every day life. Lets start out with a simple example, one that a lot of people may be familiar with.
You are shopping for a used car. The ever so convincing salesman offers you a seemingly great price, but you just aren’t that convinced its the car for you. His sale price is $2000 and he is willing to give you that price until the end of the month. But this guarantee comes with a catch, you must put down a $200 deposit to hold that price. If you choose to not buy the car at the end of the month, your deposit is forfeited and you walk away with nothing. If you decide to buy the car, you exercise your option (the guaranteed sale price) and purchase the $2000 car.
Now, lets walk through a couple possible scenarios where you may choose to exercise, or not.
Scenerio 1: You find a private listing on your local classifieds that lists the car for $1600. Even though you’ve already paid your $200 deposit, this car would still save you $200 from purchasing from the dealership (lets assume both cars are in identical condition, just for simplicity). You would choose not to exercise your option in this situation as you come out ahead $200.
Scenerio 2: You search for similar cars and find one in your local classifieds that is worth $1900. Sure, the car is cheaper. But remember that you have given the dealership a $200 deposit to hold the guaranteed sale price of $2000. The private sale would cost you $2100 ($1900+ $200) and the sale from the dealership would cost you $2000. You would choose to exercise your option in this situation.
Just by reading this example you can see how simple an option really is. If you are still unsure, I’m sure as we move along in this blog, you will begin to understand. Notice how with your $200 deposit to the salesman, you had the right to exercise the option, but not the obligation. Remember this for later.
Can I make money trading options
Lots of people ask this question, and the answer is undoubtedly yes. Now with that being said, options are one of the safest investment vehicles available, but can be very dangerous to the inexperienced investor. The way to make money trading options is to use the correct strategies. Using the correct strategies is an absolute must. Fortunes can be lost in a matter of seconds when trading options if the investor gets reckless. Greed and inexperience can send a new investor walking away feeling cheated, and ultimately broke.
The Calls and Puts of the options world
Now that we know what an option is, we can go into a little more detail as far as what we can do with these options contracts. If you are just breaking out into the options world, these two terms are ones you don’t want to forget. Over the course of this blog, we are going to be writing (selling) options, not buying. But for simplicity’s sake, I will define a call and put as if we were buying the option.
Lets make something clear before we begin discussing calls and puts. Options are a depreciating asset. As an option gets closer to its expiry date it loses value. Options can be purchased with a variety of expiration dates, but most options expire on the third Friday of each month. For example, if you buy a XYZ Sept 30 call, it means you are purchasing a call option for stock XYZ. The expiration is in September (third Friday) and the strike price is 30 dollars.
A call option gives the investor who owns the option the right to buy a stock at the specified price in the contract, a.k.a the strike price. Remember that the owner of the call option has the right but not the obligation to exercise this contract. The easiest way to explain a call is to define some relative terms, and then go over a quick example. Lets get started.
Terminology With Call And Put Options
If you are already investing in the stock market, most of these terms will not be new to you, but it is crucial to know them before you begin buying or selling options. Obviously these layouts are from Questrades platform, but should be fairly universal throughout the multiple discount brokers available.
LAST – This is the last price that an options contract has been purchased for.
CHG – This is the dollar amount that the last price above has changed since yesterdays closing price.
Bid – This is the current price at which investors looking to buy the option are willing to pay.
Ask – This is the current price at which investors are looking to sell the option.
Vol – The amount of options that have been traded during this time period (current day)
Open Int – This number displays the amount of open contracts there are on the market, ones that have not been fulfilled.
Implied Vol – The implied volatility of an option. IV can greatly influence the price of an options contract.
Strike – The Strike price of the stock being offered in the options contract.
Example Of A Call Option
Now that we know what these terms mean in the options chart, lets go over a very simple example of selling a call option.
When looking at this options table, please remember before you put an order through that those bid and ask prices are for one stock. As we explained above, options contracts come in groups of 100 stocks. Buying the AAPL Oct 117 call will not cost you $3.30, rather $3.30 x 100 or $330.
AAPL sits currently at $117.365. Lets not worry about choosing the best option on this table, but rather execute a simple order that lets you know exactly how call options work.
Buying An AAPL Oct 117 Call
If we want to purchase an Oct 117 Call option for AAPL, we would put in a limit order (I cannot stress this enough, do not use a market order) to purchase the contract at a price we feel comfortable with. Lets say we get the contract for a premium of 3.32.
We would be paying a premium to the option seller of 3.32 x100 as explained above. This option contract would come with a price tag of 332 dollars. We pay that directly to the seller. We now have the right but not the obligation to purchase 100 shares of AAPL any time before the Oct 28th expiration date at 117 dollars.
Selling An AAPL Oct 117 Call
If we would like to sell an Oct 117 Call option for AAPL, we would put in a limit order again, to sell the contract at a price we feel comfortable with. Lets say we put a limit order in for 3.35 and the order gets executed at that price.
We would be receiving a premium of $335 dollars from the option buyer. This is deposited directly into our trading account. We have now said that if exercised, we will sell 100 shares of AAPL to the option buyer at a price of 117.
Alright sure, I know how they work, but how do I make money?
Lets go over how you would actually make or lose money on each of these transactions. It is crucial to know that over the course of this blog, I will never be buying options contracts, only selling. But we will explain how to make a profit buying options contracts nonetheless.
Profit On Buying An AAPL Oct 117 Call
You now have the right to purchase AAPL shares by October 28th for 117 dollars. Considering the stock is trading at 117.35, you have just purchase an ITM Option (in the money). The price of the stock is currently ahead of the strike price. Let’s say AAPL surges in the next couple weeks to 123.55, and the expiration date of October 28th has come. You have to decide wether or not your going to exercise your option.
I would hope that this is a no brainer, even to the beginning investor. Your contract allows you to purchase 100 shares at $117 and the stock currently sits at $123.55. You would be getting the shares $6.55 below market value. You exercise your option, and sell the AAPL shares on the open market for $123.55. Lets do the math.
Premium: $332 dollars (premium paid to seller)
Option Exercise Cost : 117 x 100 = $11,700
Share Sale : 123.55 x 100 = $ 12,355
Total Profit:(Share Sale – (Premium + Option Exercise Cost)) 12,355 – 12,032 = $323
Thats a $323 profit or a 97% ROI! (Remember, you only invested $332 in the option premium)
Loss On Buying An AAPL Oct 117 Call
Lets go over 2 quick examples that end in the same result for a potential loss on a AAPL Oct 117 Call.
– If AAPL falls to any dollar amount below $117 by expiration, your option unfortunately expires useless and you lose your $332 dollar premium paid to the seller. Call options can only be exercised when the underlying assets price is above the strike price. In this case, 117.
– If AAPL hovers around the 117.15 mark until expiration, you will still suffer a loss from having to pay the $332 dollar premium to the seller. You get the stocks only .20 cents below market price, and that will not cover your $332 dollar premium. You may choose to exercise or to not exercise this option. This would all depend on your investment strategy and how you feel AAPL will look moving forward.
Profit on Selling an AAPL Oct 117 Call
You now have the obligation to sell AAPL shares at 117 on expiration if assigned notice. You have received $335 dollars in the form of a premium for selling this options contract. This will be your maximum profit you can make on the transaction. This makes selling options less appealing to the “hit it big” type investors, but a safer form of options trading in general. You make this dollar amount if:
– AAPL drops below the strike price and the option expires useless (Much more to come on this when we get into covered calls, as this can result in a loss depending on how far the stock drops)
– The option owner chooses not to exercise his option even though AAPL is above the strike price.
Loss on Selling an AAPL Oct 117 Call
Losses can be staggering when selling calls, more so naked calls. Naked calls are when you sell an option without holding the underlying security. Lets go over an example of how devastating this could be, and why I will never advocate selling naked calls.
You sell the call option, and collect your $335 dollar premium. AAPL surges to 135 dollars and on expiration day you are issued an exercise notice. Because you do not own the underlying security, you must purchase 100 shares of AAPL at 135, and then sell them to the option holder for 117.
Share Purchase : 13,500
Share Sale : 11,700
Total Loss: 13,500 – (11,700 + 335) = -$1465
You have just lost $1465 dollars in just under 3 weeks, or a -437% ROI. Remember, this is only one options contract. A lot of traders buy multiple contracts at one time. 10 AAPL Oct 117 naked calls with this result would cost you $14,650. If you were to sell a covered call, you would have first purchase AAPL at 117.36, and made a profit on the transaction. Although you would have to live with the fact you were forced to sell your $135 AAPL shares for $117, the result is still a profitable transaction.
Rounding it out
I hope you enjoyed reading the first part of our options trading blog. For the experienced options trader this may have been a bit dry. We will be getting into options trading strategies later on. For the new investor I hope you have a basic idea of what an option is.