Stock Options Basics For New Investors

I have decided that discussing stock options basics for beginning investors with no previous experience at stock options trading might be worthwhile. I’ve received a few comments that indicate that readers would appreciate if I could explain option trading with clearer definitions of options terminology, along with another explanation of the basics that is less wordy than the ‘stock options explained‘ article that leads off this site. I’ll do my best.

Stock Options Basics: Seeing Both Sides of the Trade

Financial exchanges created options as investment products which give people more choice as to where to put their money. Rather than simply buy or short stocks, options give you the chance to diversify by using investment funds in two primary ways. Continue reading Stock Options Basics For New Investors

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

Finding Your Own Stock Option Picks

Stock Option Picks – Seek Out Good Tools, Not ‘Answers’

Many new investors, having gotten a taste of the potential for profits offered by trading stock options, begin to look for ways to automate the process of picking specific stock options contracts that might have a better than average chance of appreciating before their expiration date. With thousands of stocks having options issued on them and often dozens of combinations of different strike prices and expiration dates, it would be impossible to manually sift through every contract on a daily or even weekly basis.

When it comes to stock option picks however, let’s be clear: think twice before you let your desire for consistent options trading profits compel you to subscribe one of the hundreds of newsletters available on the Internet and elsewhere that promise you barely believable gains. I’m not saying that all of the advice one gets from people selling options picks is bad; I am saying that it is no automatic shortcut to options profits.

On the other hand, when it comes to finding profitable options trades there is no substitute for doing your own research. Listen to everyone, but look for tools that will help you reduce all the market data to trading opportunities that are especially promising, and assume responsibility for your own trades.

There’s little doubt that some investors have found methods to profit consistently with options, but let me ask you a question. If you found a way to reliably pick stock-option winners-I mean really reliably-what would motivate you to sell either your method or a roundup of weekly or daily option picks derived from signals as indicated by your method? Admittedly, selling stock option predictions to hundreds of people each month would represent an attractive income but it would not approach what you could earn for yourself if you had really found a way to make money consistently with options.

In this article, rather than pointing you to specific free stock option picks I’d simply like to remind you what is important and useful if you have made the decision to try to make money trading options for your own portfolio. It’s necessary to distinguish between offers to sell you investment advice on particular options, and offers to purchase or subscribe to tools to help you make your own decisions. Covered call screeners and many other types of option trading software fall into the latter category and are worth learning about.

While these tools imply that you’ll have to do your own work I would suggest that buying tools or access to tools that help you responsibly arrive at your own stock option picks (and hopefully learn from your own mistakes) is more viable than making a leap of faith and paying for dubious advice. There’s a reason for the familiar disclaimer in the fine print of every financial prospectus: “Past performance is not indicative of future results.” It’s there because it’s true! Start your options trading journey by getting stock options explained properly.

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.