Options Trading Explained-Buying Stock Options

As I have used this site to simply explain stock options to beginning investors, I’ve also been asked from time to time to take a slightly different direction by readers who would like to get options trading explained to them. I’ve been a little bit reluctant to extend the scope of this site beyond its title–stock options explained–because of the risky nature of options, especially in the hands of neophyte investors for whom buying, or going long, puts and calls is the most natural way to approach options trading. Providing basic education to investors  on stock options is one thing, but I would hope that no one would interpret their understanding of options basics as an indication that trading them successfully is anywhere near as simple, because it is not.

Still, I thought there might be some benefit in explaining Continue reading Options Trading Explained-Buying Stock Options

Explain Option Trading In Terms Of A Risk Continuum

Don’t let the word ‘continuum’ make you click away; my point is that most investing neophytes think of stock options as risky investments and it’s just not the whole story. While it’s true that going long with calls or puts means that you are risking most or all of your investment funds in that particular position, it might be helpful to explain option trading in terms of a risk continuum, because the fact is that there are conservative option strategies as well as risky ones that traders can employ.

The idea of using just a little bit of money to control 100 shares of stock per contract that one buys, thereby benefiting from potential moves in the stock that one anticipates, is attractive for some traders or investors (and lots of speculators!). Certainly leverage has a place in some portfolios, to be taken on with only a small percentage of one’s investment capital. The stories one hears of traders doubling or tripling their money in a week or less certainly are accurate, though as you might expect the likelihood of this happening is quite low for most people, certainly much less than 50%. Having said that, one can still use a strategy of buying puts and calls when one has a hunch that a move might occur in the short-term. While long-term options, called LEAPS, can be employed successfully if you have a longer time horizon, buying options is usually done with an eye toward a short-term gain because of the time decay that premiums suffer as a contract gets closer to its expiration date.

So let’s look at the other side of this continuum. Many people with larger portfolios use writing, or selling, puts and calls as a way of augmenting their portfolio such that they actually reduce their overall risk exposure. If you think of options only as risky investment vehicles then that might surprise you-here’s how these conservative option trading strategies work: Continue reading Explain Option Trading In Terms Of A Risk Continuum

Option Trading Strategies-Selling Options

The Easiest Money And The Dumbest Trade I Ever Made

Here at stock options explained we have covered options trading strategies such as simply buying stock options and also selling options, with the idea that stock options basics could best be conveyed from the standpoint of actual examples behind trading strategies, rather than simply limiting our discussion to theoretical ideas. At any rate, in this vein I thought it might be of interest and helpful to illustrate option trading strategies from a real-life example that’s of particular interest to me. I’ll show how selling options involves more than the risk of having your options exercised so that your stock is called away from you (if you’ve written calls) as it rises well beyond the strike price and you miss out on further gains beyond the strike price. There is an additional danger, one not related to opportunity cost.

In this type of trade, while you will receive some protection from selling options because of the reduced cost basis for your stock (as you receive a premium amount from the option buyer), this lower cost basis might be no match for the amount by which the underlying stock could fall. In other words, using this trading strategy one may sell covered calls against stock he owns and get to keep the premium if those calls expire worthless, but still take a much larger hit because of a drop in the stock price. You might think you’re buying some protection after a run-up, but the market might have much bigger plans!

I would like to illustrate selling options in this context not with call options, but with a trade involving put options. I had a front row seat on this particular trade, as it was I who was doing the trading! The mechanics with selling puts are the same as with selling calls, though your directional preference is reversed with puts. One can write covered, out of the money puts as a way to insure a short position, hoping that the worst that will happen is a drop below the strike price, below which he no longer benefits at expiry as he must cover his short position at the strike. If a trader employs fairly complex option trading strategies of this kind is also fully aware that the stock price could rise, which could easily outweigh that put premium amount that he receives for writing his covered puts. I said “he” but I might just as well have said “I”. Well, here we go.

Flash Crash!

If you were anywhere near planet Earth during the week ending May 7, 2010, you might remember how quickly the market dropped from above 1200 on the S&P 500 down to a low on the day of the “flash crash” (May 6) of 1056. The market bounced off the flash crash lows, closing the day out at 1128, but the next day, Friday, May 7 was also ugly, with the S&P 500 closing that day at 1110. The reason I remember the events so clearly is that I sold put options a few minutes before the close of trading on that Friday, a move that I have thought of ever since as both the easiest money and possibly the dumbest trade I ever made.

I’ll elaborate a little. For once in my life I had made a correct move and was short SPY from above 120. SPY is a heavily-traded ETF based on the S&P 500, and is a convenient proxy for the overall market. The VIX (a popular volatility indicator) was low and the markets, though they had been grinding higher for months, seemed to me to be ripe for a fall. I decided not to use options for leverage, so I could wait. Well, like everyone else I was stunned by the events of Thursday, May 6, when the Dow Jones Industrial Average fell almost 1000 points. I remember watching CNBC, which had a live feed from Athens, Greece, where there were real tensions over austerity measures imposed by the Greek government. As things appear to start to get out of control there on the streets of Athens, action in the markets worldwide seem to mirror the possibility of real calamity. Even though I was short, the speed of the events unfolding left me utterly flat-footed vis-à-vis my position, and while someone with a clearer head might have chosen to cover his short position when the market was down over 10% in just one day, I did not do so.

The next day I watched again as the bounce that the whole world seemed to be hoping for after the chaos of the “flash crash” did not occur. That Friday was nowhere near as ugly as the previous day but the market was again down nearly 4% intraday.

As the market neared the close on Friday I remember my thought process very clearly: while the market was clearly very oversold it seemed that the upward trend had broken so violently that we were headed dramatically downward again over the next few weeks. Still, with the volatility so high at that moment options premiums were extremely inflated, especially for put options. What this means is that if one were to write put options against an existing short position one would receive, relatively speaking, a very large premium amount simply for promising to buy back shares-or cover his short position-at lower levels, even much lower. One way to look at is is that you could be paid for profiting even further from your short position. Now, there are legitimate option trading strategies for every market situation, and at a time like this capturing volatility is often smart, because even if the market continues down at a slower rate (or stays even) one could see a reduction in the component of the premium that had been inflated due to the volatility (if we are talking out of the money options, that would be 100% of the premium, of course).

On this particular day I was able to sell five SPY May 100 puts against the 500 shares of SPY that I was short, for 1.05. SPY was just a hair over 110 when I wrote these puts, so that means that with only ten trading days left before expiration that SPY would have to go down a full ten points for them to be in the money. After that terrible week it seemed very unlikely that it could happen so quickly, but I told myself that if the overall market experienced another 10% decline during those two weeks I’d be happy to get 20 points on the SPY out of the trade that fast (I was already ten SPY points lower than my entry, remember). The approximately $500 I received from selling options to a trader or traders who were willing to bet $100 per contract that SPY would be over ten points lower in ten days (just to reach the strike price), seemed like the easiest money I’d ever made. Hopefully the puts would expire out of the money, worthless, I would keep the premium and then in the next several weeks I’d eventually see SPY below 100, maybe much lower, with me looking great on my still-intact short position.

Well of course anything might have happened, but what did happen was that the market bounced on the open Monday and into the earlier part of the week. When I covered my short position several points higher I got to keep almost all of the $500 I’d received in premium for selling the puts (yay!). However, my gains from my short position were a few thousand dollars less than what they might have been had I simply covered my short on the preceding Friday, rather than fixating on how likely it was that I’d keep most of the premium!

I don’t fault myself for not being clairvoyant, and I think that the only mistake I really made selling options here was overemphasizing the likelihood that I would keep most or all of the put premiums, relative to the possibility that a violent snapback could occur and quickly negate that $500 position. Still, both trades were profitable, and my actions were in line with the old adage “cut your losses and let your profits run”. Well, they also say that no one ever went broke taking a profit, and might have been was a large one! Maybe I have overemphasized how silly I feel not simply taking a huge, quick profit (heck, I’m sure I’ve made dumber trades) but in any case, for purposes of getting option trading strategies explained to readers of this site, I think this anecdote has value.

Options Trading Strategies-Two Basic Ways To Play

If you’re trying to understand option trading strategies, and terms like strike price, expiration date, time decay, and covered and uncovered calls and puts, there’s a basic understanding that you should have, an overview of stock options basics in terms of two diametrically opposed strategies, that will help you understand both buying options and selling options (aka writing options). As the scope of this site has expanded, I’ve seen that the best way for new investors to have stock options explained to them is from the perspective of option trading strategies rather than simply theoretical articles about options basics.

If you’re familiar with options only as a trading vehicle that some investors use to attempt to make huge gains very quickly, you probably have wondered what terms like “writing calls” and “naked puts” are all about. The fact is that the risky buy-side trades with which new investors are most familiar is just the tip of the iceberg when it comes to the range of ways one can use stock options to maximize the performance of their overall portfolio.

Every options transaction has a seller on the other side of the transaction from the option buyer. This makes intuitive sense, but maybe you have assumed that the option seller is an options exchange or even some large broker. This is incorrect. The fact is that anyone can sell puts and calls just as they can buy them (pending approval from your broker, who will want you to attest that you understand options well enough to approve you for trading them in the first place).

But why would I sell options, rather than buying them? The difference lies in the motivation underlying both sides of the trade. I’ll explain call options here.

Whereas the buyer of the right to buy 100 shares of stock at a given price by a given date in the future is looking for a method to leverage a relatively small amount of money for the possibility of a large percentage gain, the seller of that right is most often looking for a way to protect long stock positions that he already has in his portfolio. There is an exception to this, in the form of very risky sell-side option trading strategies known as uncovered or “naked” call or put selling, but I’ll save that stock options explanation for the end of this article to avoid confusion.

Essentially the option seller is selling the right to purchase shares that he owns at a “strike price” that he would be happy receiving for his shares, should they reach that price. Normally the seller will pick a strike price higher than where the stock is currently trading. In return, the option contract seller or writer receives a premium amount from the option buyer.

For example, if I own 1000 shares of IBM and the stock is at 140, I can sell ten option contracts of IBM 160 calls, and I will receive an amount of money from the buyer or buyers of these 10 contracts. How much money depends on how far away the expiration date is, the volatility of the stock and other factors. Should IBM be trading over 160 by the expiration date, my stock will be called away from me i.e. I will be obligated to deliver it to the buyers of the options in return for the premium that they paid me. Note that I am still happy because I experienced appreciation between the 140 level and 160, plus the premium payment, although if IBM rises to say, $200 per share before expiration I will most likely regret selling calls against my shares in the first place!

If IBM falls or at least stays below 160 strike price between the day I initiate the trade and the expiration date, then the options will expire “out of the money”, worthless. That means that I no longer have the possibility of having to deliver my shares; the transaction is concluded at the expiration date. If I’m the option seller I keep one hundred percent of the premium amount, minus commissions, and unfortunately the option buyer loses whatever he paid to enter the transaction. Regardless of where the stock price is at expiration in this situation, my cost basis for my shares has been lowered by the amount of premium that I received.

In this example the call buyer is bullish (i.e. optimistic) on the stock and the call seller is bearish, or at least not overly bullish (after all he’s not bearish enough to sell his shares). It might have occurred to you that just as a put buyer is bearish on a stock that the put seller must be bullish (or at least not excessively bearish). This is an accurate assumption. This implies that ultimately one can’t think of either buying or selling options as bullish or bearish trades, as you could be a call buyer or put seller if you were bullish-to-neutral, and a put buyer or a call seller if you were bearish-to-neutral.

Options selling versus buying is more properly thought of in terms a risk/reward profile that a person wants to assume when he makes a trade. The buyer of the put or call is prepared to lose much or all of the premium he pays if the trade goes against him in return for the possibility of relatively large gains very quickly. The seller of a put or call is interested in making a relatively small profit on an open position where he is either long or short the stock, often with the only potential downside being the opportunity cost of having his stock or short position terminated at expiration if the option is in-the-money. Either way, the option buyer buys risk; the option seller is hedging with an eye on security and a smallish gain.

Well, as with many things, good way to explain option trading strategies is in terms of a dichotomy. Reality has exceptions, and options trading also has an interesting exception to the buy risk/sell to hedge opposing strategies.

I promised to explain one way in which option selling is very risky; this option trading strategy is actually much riskier than buying options. Selling covered calls means that you own the stock against which you write the calls. Selling “naked” calls means that you do not own the underlying stock if you are selling calls, and if you are selling “naked” puts, that you are not short the underlying security.

Wait a minute. How can anything be riskier than the possibility of losing your entire premium amount when you buy a put or a call? Here’s how naked option selling works on the call side (fasten your seatbelt!):

In our initial example of selling IBM 160 calls against shares that we own when IBM is trading at 140, the premium we received functioned as a hedge against a possible downward move in the stock. Believe it or not is perfectly legal to take the premium from the call buyer without owning any shares of the underlying stock. Should the stock close at expiration below 160, the call seller keeps his premium without having to have taken any further position, i.e. lay out any money for the shares of stock, as the seller of a covered call does. Assuming that the writer of a naked call holds his position until options expiration, you can say that he has an infinite return (minus commissions of course!). Sounds wonderful doesn’t it? And so what happens in the event that the stock is trading above the calls’ strike price at expiration?

The naked option seller is required to deliver 100 shares of stock per contract that he has sold. The premium he has received is miniscule compared to the amount of money he needs to pay for a stock position that he will establish at the strike price. In our example above, the naked seller needs $160,000 to buy 1000 shares of IBM at 160 to fill his obligations. You don’t need to do much more than read that sentence again to understand the amount of risk a naked options seller is assuming.

Now in practice, online brokers-in addition to furnishing you with stock option software-require you to maintain equity in your account to cover obligations that you have in delivering stock that you might be obliged to deliver. Still, the possible downside from this trade is such that even though one does not have to purchase shares, you must be psychologically and financially prepared to do so. Needless to say, writing naked puts or calls should only be attempted if you are an experienced options trader, and it is one of those options trading strategies in which most investors will never participate.

My hope is that you have found a fairly comprehensive overview of the two basic strategies for options trading explained here. Please let me know if you would like further elaboration in the comments.