Table of Contents
- Introduction
- Understanding Calls and Puts
- How to Pick the Right Options Trade
- Two Ways to 'Time' Your Trades
- The Key to Success in the Options Market
- How to Limit Your Losses
- How to Calculate Risk and Reward
- How to Determine Proper Position Sizing
- A Brief Options Glossary
- Three Major Factors that Determine the Price of Options
- Figuring Profit Potential
- How to 'Unlock' Your Brokerage Account for Options Trading
Introduction
When you talk about options, most people think of risk... dangerous leverage... speculation... gambling...
There is that aspect to it, if you don't know what you're doing.
See, most people don't understand options. The reason they were created in the first place is to reduce risk. In fact, the original options were designed to help investors hedge their portfolios against bad moves in the market.
Unfortunately, what's happened over time is what happens to a lot of good ideas on Wall Street... options have morphed into a commission-generating vehicle they sell to folks as a way to get rich quick.
If you think trading options will help you get rich quick, I've got some bad news for you. Using options can make you a lot of money, but it's not going to happen overnight. Trading options is a process. And if you want to be in the options market for any length of time... you have to do it the "right way."
Learning the "right way" to use options might involve a little extra effort on your part if you want to trade in the market successfully. But we can help you master the basics... Your NewsWire Premium editors – C. Scott Garliss, Greg Diamond, and John Gillin – have traded options for a combined 50 years. During that time, we've also taught folks just like you how to reduce their risk with options and add a little bit of "pop" to an otherwise conservative portfolio.
This report contains everything you need to know about options and nothing you don't. First... here are a few things you must keep in mind…
Truth No. 1: Buying and selling options is about the riskiest and potentially most rewarding game on Wall Street.
Options as a Strategic Investment by Lawrence McMillan is the Bible for options investors. His message is simple: "With proper knowledge of their underlying principles, most investors can understand options."
The most important thing to know about options is that they are a "wasting asset" – an initial investment that declines as time passes.
Think of it this way... You want to own the latest and greatest tech company – Company X – because you love the product and think it's cheap right now relative to its long-term potential. But it trades for $50 a share.
Instead of buying 100 shares of Company X for $5,000, you can buy a call option instead. One call-option contract will give you control over the same 100 shares of Company X. But it will cost you much less...
In March, you buy a September Company X $50 call for $2. Your cost will be $200 ($2 cost x 100 shares).
Buying this call option will give you the right, but not the obligation, to buy 100 shares of Company X at $50 on or before expiration day (the third Friday in September). In this example, we are just trading the option and will be out before the option expires.
If Company X rises 20% from $50 to $60 prior to expiration, the $50 call option will be worth $10. Your $200 outlay is now worth $1,000!
Instead of paying $5,000 for 100 shares of stock... you've paid $200 for 100 shares of stock and could see a 400% return instead of a 20% return.
But you must be careful... If your timing is off and the stock does nothing or even sells off, you will quickly lose the $200 premium you paid. Your investment will be wiped out.
Options pay you when you are right. But the clock is ticking. And if the stock does not move up, then like poker, your bet is taken by the house.
Truth No. 2: Want to be a winner? Watch your losers!
To succeed in trading options, you really need to limit your trading to opportunities that have at least a 3-to-1 payout. A 5-to-1 reward-to-risk ratio is better. But at minimum, you want to have the potential to pocket $3 in return for every $1 you risk.
You accomplish many things by forcing a minimum 3-to-1 discipline on yourself. For one, it forces you to think in terms of reward and risk, which is extremely important. Most failed options traders, even ones that may have had good trading systems, fail because they didn't pay enough attention to risk. If you're willing to lose 50% on a position, you'd better be expecting a gain of 150% or more – at least. That's a tall order.
If you're willing to lose it all (meaning have the potential for a negative 100% return on a position), you'd better be expecting a 300%-500%-plus gain in that position.
When you see it in terms of risk versus reward and you realize that 500% winners don't come along every day, you can see "risking it all" is a bad bet.
Options are a lot like poker. Your hand is only a small portion of the battle. Betting appropriately for the entire game is really what's important, which leads us to...
Truth No. 3: Big winners make small bets.
You've got to know when to hold 'em and know when to fold 'em. But you'd sure hate to fold 'em and take a total loss with a big bet on the table... So don't ever put yourself in that boat.
Limit the size of your positions. You should only have 2%-3% of the money you've set aside for trading at risk on any one trade. We really can't imagine any combination of circumstances where you should consider putting more than 10% of your trading money on one play. Don't do it!
You've got to stick to the program. Limit the size of your positions. And limit your downside by never allowing a small loss to turn into a big loss.
Traders who follow this have a chance of being winners in options over the long run. Those who don't do this will be quickly drummed out of the club, taken for every penny.
Now, let's talk about the basics of call and put options…
Understanding Calls and Puts
As an individual investor, you can trade one of two main types of stock options: calls and puts. Let's take them one at a time...
As we said, buying a call option on a stock gives you the right (but not the obligation) to buy 100 shares of that stock at a set price at some point in the future. That agreed-upon price is called the "strike price." And as the holder of the option, you can exercise your option and buy shares at the strike price any time before the option's expiration date.
If you think a stock price is going to rise... you could just buy the stock. That's what most people do. But you can magnify the returns on the capital you put into the trade by buying a call.
In short, remember... Buyers of call options want the stock to go up. They only make money if the stock goes up.
Now let's cover the basics of a put option...
Puts are essentially the opposite trade from a call. When an investor expects a stock to decline in value, he or she can short a stock or buy a put option.
As an example, imagine a company's stock trades at $10 a share. The premium to buy a put expiring within two months is $1 share. An option contract always represents the right to trade 10 shares. So to buy 10 contracts, your cost is $1,000 (100 shares x $10 = $1,000.)
If the stock declines substantially, the value of the put goes up and the owner profits by selling the put. But if the stock rises, the put buyer (owner) has limited risk. He or she can only lose the value of the original investment ($1,000).
In this simple example, YOU CAN ONLY LOSE $1,000 if the investment does not play out.
Think about it, the puts can't trade below $0 per share. So the put buyer has limited downside risk as the stock price rises. But as the stock price falls to $0, the put buyer's profits can be awesome.
So remember... at its heart, trading puts is the opposite of trading calls: Buyers of put options want the stock to go down. They only make money if the stock falls.
How to Pick the Right Options Trade
One of the reasons many people shy away from the options market is that there are hundreds of options to choose from for any one stock.
An option is a contract. It gives you the right to buy or sell a stock at a specific price by some predetermined date in the future... And picking the best one can be confusing.
For example... One reader e-mailed in with a question about buying call options: "How do you know which option to trade?"
In this report, we'll use a hypothetical example to see how to choose options...
You can buy iShares Silver Trust (SLV) calls that expire in a few weeks... Or you can go all the way out to January 2019... Or you can pick from any number of expiration dates from months in between.
You also have a number of strike prices to choose from. That's the price at which you can either buy (in the case of call options) or sell (in the case of put options) the underlying stock.
Picking the right option can be a tough decision. And it often makes the difference between a good trade and a bad one. So next, I'm going to teach you how to pick the right option.
First, let's get one disclaimer out of the way...
What you're about to read is a historical example of how to select an option on SLV. It is for educational purposes only and is not a recommendation. All the prices are old and the options expired, so you can't open this trade now.
Also, remember... option trading involves risk, and you can lose all the money you put into the trade. While there are ways you can limit your downside (as we'll also show you in this report), do not risk more than you can afford to lose.
Now, let's figure out how to pick the right expiration month...
Two Ways to 'Time' Your Trades
When you buy an option, you're buying time for the stock to do something. The more time you buy, the more expensive the option. You want to be sure to buy enough time for the stock to complete the move you're anticipating. But you don't want to pay extra for the time you don't need...
If you're anticipating a stock will move higher because of some fundamental factor – like a positive earnings report or a favorable introduction of a new product – you need to buy an option that expires after the event.
For example, if you think XYZ biotech stock is going to shoot higher after an FDA (U.S. Food and Drug Administration) meeting in late May, you need to buy an option that expires in June. An April contract does you no good.
There's no point buying July or August options in this case, as you'd simply be paying for time you don't need.
However, if you're buying an option based on a technical chart pattern for a stock... things get a little trickier.
Some chart patterns resolve quickly. Rising and falling wedges, for example, usually lead to sudden moves in the stock once support or resistance is taken out. In these cases, you can trade options with short expiration dates.
Consider what was happening in 2012 with the iShares Silver Trust (SLV), an exchange-traded fund designed to mirror the price of silver. At the time, the fund was tracing out a descending-triangle pattern...
This is typically a bearish setup where a stock makes lower highs and keeps pounding away at the same support line. But occasionally, support holds up and the chart breaks out to the upside of the triangle. It all depends on the probable outcome of the risk/reward setup...
Here's how you could have used options to play the 2012 setup in SLV...
In July, silver traded around $27.30 per ounce. It had solid support just above $26... a downside risk of about $1.30. But it could have reached $32 on an upside breakout... $4.70 higher than its price at the time.
A descending-triangle pattern breaks to the downside about 60% of the time. So you would have had a 60% chance of losing $1.30. That's a probable loss of $0.78 (60% of $1.30).
A descending-triangle pattern breaks to the upside about 40% of the time. So you would have had a 40% chance of making $4.70. That's a probable profit of $1.88 (40% of $4.70).
On an "even money" basis, silver buyers would have risked $0.78 to make $1.88. Mathematically speaking, you'd have to take those odds.
Based on SLV's prices, you could have bought the SLV August $26.50 calls – giving you just one month of time premium for the potential to make triple digits if silver rallied. And you should always protect your downside with a stop loss.
By August option expiration, silver looked poised to break out to the upside. If you sold the original August calls before expiration and bought more SLV calls expiring later, you could have eventually closed out of the position for a nearly 80% gain.
Selecting the appropriate expiration date is one of the basics of picking the right options trade for you. Based on the charts, you determine how long the setup you're trading should take to play out... and place your option bet based on that.
Next, we'll look at the key concept a successful options trader needs to understand before jumping into the market...
The Key to Success in the Options Market
Options traders need to understand probability. What are the odds a stock will move in the direction you expect it to?
A stock can do three things...
- It can go up.
- It can go down.
- It can stay the same.
So by betting on one of those outcomes, you have a 33% chance of getting it right. In other words, for every three option trades you make, you're going to have one winning trade and two losers.
This seems simplistic. There are strategies traders can use to improve their odds, and there are mistakes we can make that reduce them. But for the most part, a 0.333 batting average is a safe assumption.
So if we're only going to make money on one out of every three trades, we need to make enough on the one winner to counter the two losers. Since the losses can be as much as 100% each, it's important to only consider trades that can produce 200% gains or more.
Of course, we're not holding out for gains of 200% on every trade. That's unrealistic. And we won't suffer 100% losses all the time, either. But the potential for a 200% gain has to exist for a trade to offer the proper risk/reward setup.
That potential is what we look for most when deciding which strike price to buy on an option.
Let's take another look at the options trade from earlier: buying the SLV August 2012 $26.50 options. And let's see how to narrow down which strike price offered the best setup for the trade...
Here's a look at the pricing of some of the August 2012 options with strike prices close to the price of SLV shares as of July 2012 ($26.50)...
Let's say we had an upside target of $31 per share for SLV stock by option-expiration day in August. It's really just a matter of simple mathematics to determine which option would give the best return based on that target price.
But SLV could have run into resistance at $29. It was possible the stock could get pinned at that price and fail to break out to the upside... So you would have also needed to consider how the trade would work if SLV shares got stuck at $29 rather than jumping all the way to $31.
Here's the minimum price for each of those option contracts if SLV had hit the target prices of $29 and $31 by option-expiration day in August...
Three of the four options offered the potential for at least a 200% return on the trade if SLV rallied to the upside target of $31. So it had a favorable risk/reward setup. The August $25, $26.50, and $28 call options, however, would have been profitable at the lower $29 price target.
The August $29 call option offered the highest potential return. But it also had the most risk if SLV couldn't get above $29 a share.
The SLV August $26.50 call option looked better.
The option cost less than half the premium of the August $25 call. So you could have cut your potential risk by more than 50%. And the potential returns were higher at both the $29 and $31 price targets.
By choosing the SLV August $26.50 call option, a trader could take on less risk and get a much higher potential reward.
Since each option contract covers 100 shares of stock, it would have cost $950 to purchase 10 SLV August $26.50 call options ($0.95 premium x 100 shares per option contract x 10 contracts). A trader would have the potential to make more than $3,550 on this trade if SLV rallied to $31 per share.
Remember... this is not a real recommendation. We're just using it as an example for how to choose the appropriate option.
Now let's move on to how to protect your downside...
How to Limit Your Losses
In the case of SLV, you'd want to set a stop of 50% on the trade to limit your potential losses. That means if the options lost 50% of their value, we'd admit we're wrong on the trade and get out of it with a $475 loss. So we'd risk $475 in an effort to potentially make $3,550. That's more than six times as much potential reward as risk. That's a good setup.
Of course, this setup requires that you stick to your original plan and cut your losses if the option loses half of its value. That seems like an easy enough thing to do. But most people – including experienced traders – have a tough time cutting their losses. It can be emotionally painful. So here's a different tactic...
If you struggle with discipline, you need to find a way to limit the dollar amount of your losses if the option goes to zero. In the previous example, we were willing to risk $475. But if the option goes to zero, the loss would be far worse – $950.
Instead, we could take an option position where the initial investment is less than $475 at the outset. We could buy 10 of the SLV August $28 call options for a total of $500 ($0.50 premium x 100 shares per contract x 10 contracts). If we were right and SLV rallied to $31, these call options will be worth at least $3,000. That's a gain of $2,500.
Yes, that's less than we'd make with the SLV August $26.50 calls if we're right on the trade. But the risk is now just $500 – even if the option goes to zero.
When trading options, the emphasis is on limiting your risk.
Figure out how much you're willing to risk on a trade, and then select the option that offers the best risk/reward scenario based on your risk tolerance. Be honest with yourself. If you struggle with cutting your losses – and most traders do at one point or another – set up a trade where a 100% loss is less in dollar terms than the trade with the best setup.
How to Calculate Risk and Reward
In every option trade, we establish a target price for the stock. Most of the time, we base this on technical analysis.
For example, in late 2012, shares of Facebook (FB) presented a compelling opportunity. (In hindsight, it was the buy of a lifetime.)
The stock had a rocky debut. After its initial public offering, it tanked from $40 a share to $17.55. Management was called out as inexperienced. And the stock's valuation was questioned. But none of that changed the fact that about 800 million people were using the service... and the call options were ridiculously cheap.
We opened the trade in September 2012 by buying the March 2013 $25 calls for $2 a share. In other words, we paid $200 ($2 x 100 shares per contract) for the right to buy 100 shares of Facebook at $25 each by March 15, 2013. (Options contracts usually expire the third Friday of the month.)
The stock was trading at $20 at the time. Paying the equivalent of $7 more than the current price (the $25 strike plus the $2 premium) might appear rich. But we expected the stock could go to $30 a share in six months.
The trade worked out well. The stock went to $32 per share. We ended up selling the call for $12 in early 2013, locking in a 71% gain.
The point is the option market provided a cheap way to buy a great asset. The stock was on sale and the risk/reward was skewed in the buyer's favor.
Another real-world example...
Microsoft (MSFT) was stuck in a sideways pattern for 12 years (2001-2013). The company had a brilliant product (Windows), but it traded like a utility. Its margins were stagnant and innovation was stale.
Then everything changed in June 2013… Microsoft announced it would support Oracle Corp. software on its cloud-based platforms to improve its chances against smaller, more nimble competitors.
In August of that year, embattled Microsoft CEO Steve Ballmer announced he would be retiring. And the search was on for someone to take the company in a new direction.
Toward the end of January 2014, word leaked out that Satya Nadella was likely to be named the new CEO. He had come up through the ranks and was known for his ability to span and transform multiple products within the organization.
In February, Microsoft had promoted Nadella to CEO of the organization, increasing its focus on Cloud Computing and the next big chapter of growth.
The trading pattern – which you'll hear traders refer to as "the technicals" – showed several days where the intraday action in Microsoft's share price staged a series of higher highs and higher lows. That usually signals a bottom in the stock is setting up.
This technical indicator aligned perfectly with the company's announcement that it was hiring a new CEO…
Plus, the company was making gains in the new area of "cloud computing." A new age leader and a high-margin business opportunity was just what the doctor ordered.
At that time, call options were cheap because expectations had been so low for so long.
But an astute call buyer could see that the risk/reward was skewed in your favor. There was solid support at $31 a share (the September 2013 low).
Around this time, you could have bought a July 2015 $40 call option. The stock was entering an uptrend and you would have had a year for the investment to play out.
In this case, the stock moved up quickly to the $40 strike price. It climbed to $49 over the next six months…
You could have sold the call option at any time after the stock moved above $40 and before the July 2015 expiry for a large gain.
Even though the options set up well, we figured it would be more profitable over a longer time frame to own the stock outright. So we wound up buying the common stock instead. We were convinced of the transformation Nadella was going to effect at the company, we wanted to remain long-term holders beyond expiration.
How to Determine Proper Position Sizing
The most common mistake option buyers make is that they overleverage. In other words, they buy far more options than their account size justifies.
Never forget: One option is the equivalent of 100 shares.
Traders should use options as a substitute for the underlying shares. In other words, if you typically buy 1,000 shares, you should buy only 10 contracts. If you trade in lots of 500 shares, you should buy just five contracts.
Of course, most people don't think that way. Most people think, "I can deposit $10,000 and sell short 1,000 shares of Company X at $10 a share, or we can purchase $10,000 worth of put options."
This type of thinking is foolish. Rather than using options to reduce risk, they've actually increased their potential maximum loss. Instead of substituting 10 puts for their normal trade of 1,000 shares, they've overleveraged and bought 100 puts, which cover 10,000 shares.
One of the annoying characteristics of options is that they have this nasty habit of expiring worthless. Consequently, you have to be willing to accept the potential loss of 100% of the capital you put at risk in options.
So you should never, never, NEVER buy more put options than you need to control the number of shares you normally trade.
A Brief Options Glossary
Anatomy of an Option
This option is betting that Microsoft's share price will be above $30 on option-expiration day in April, which is the third Friday of the month.
Underlying Asset: The stock, stock index, or any other financial instrument that you have the right to buy and sell.
Premium: The price of the option.
Expiration Date: Options expire on the third Friday of the month. You must sell on or before the expiration date.
Exercise: You can either sell your option, or exercise your right to buy (in the case of a call) or sell (in the case of a put) the underlying instrument at the strike price.
Bid: The highest price option buyers are currently willing to pay.
Ask: The lowest price option sellers are currently willing to accept.
Strike Price: The price at which you can "exercise" your option. This price is based on the underlying instrument. Call-option buyers have the right to buy the underlying instrument at the strike price. Put-option buyers have the right to sell at the strike price.
In the Money: Calls are "in the money" if the price of the underlying instrument is HIGHER than the strike price. Puts are "in the money" if the price of the underlying instrument is LOWER than the strike price. (A put with a $20 strike price is "in the money" with the stock at $19.)
At the Money: When the price of the underlying instrument is identical to the strike price. Same for both puts and calls.
Out of the Money: Calls are "out of the money" if the price of the underlying instrument is LOWER than the strike price. Puts are "out of the money" if the price of the underlying instrument is HIGHER than the strike price. (A crude-oil call with a strike price of $25 is "out of the money" if crude is at $20.)
Symbol: The basic parts of an option symbol are: Stock Symbol + Expiration Year + Expiration Month + Expiration Day + Call/Put Indicator + Strike price. You can see how this works in the earlier example.
Three Major Factors that Determine the Price of Options
1. Distance of the Strike Price from the Market Price: For out-of-the-money options, the closer the market is to the option's strike price (the closer the option is to being "in the money"), the more expensive the option will be.
2. Time Until Expiration: The longer an option has to work, the more expensive it will be. Extra time simply gives the stock more time to make the move. An option is known as a "wasting asset." It loses value with the passage of time.
3. Volatility: The more volatile the stock, the more expensive the option will be. Because volatile stocks have greater potential for large price moves, there's a higher probability that an out-of-the-money option will be in the money at some point.
Figuring Profit Potential
Profit potential for both buying and selling options is typically figured at expiration. At expiration, hard-to-figure pricing variables, such as time and volatility, drop from the equation... making profit calculations much easier.
However, that doesn't mean you need to hold an option until expiration, and you do not need to exercise your option to profit from a position. To take a profit on a put or call, simply sell it. You can also cut losses in losing positions by doing the same thing.
The vast majority of options are not carried through until expiration at all. Rather, they are sold on the options-exchange market.
Below, there are some simple formulas for figuring risk and profit potential, based on the market price of the underlying instrument at expiration.
How to 'Unlock' Your Brokerage Account for Options Trading
Unless you know how to "unlock" your brokerage account, you can't do any trades using options. Fortunately, it's an easy, two-step process...
First, ask your broker for an "Options Account" form. It's a simple form that only takes a few minutes to fill out. But you need to complete it to authorize your brokerage account for trading options.
It will differ from broker to broker, but you'll likely need to be approved to buy calls and puts. Your broker will look at your trading experience and the amount you have in your trading account to determine what level to grant you.
In most cases, you can get the forms online, fill them out, and either fax them back or mail them to your broker. Once you fill out the forms – which should take you about five minutes – your account should be approved shortly. Most of the top names in the business can open options accounts for you easily and quickly.
Second, enter the 15-digit call-option ticker symbol. The ticker symbol specifies the underlying stock, strike price, and expiration date of the call. Every time we recommend a trade, we'll provide the exact ticker for the trade.
When trading through your online brokerage account, you'll first select the underlying stock you want to trade against. Somewhere on the screen (depending on the website's design), you'll see a link to that stock's options. Click on the link, and you'll be presented with a list of options and their corresponding ticker codes. You can then select the one with the strike price and expiration date you want. In most cases, the code will automatically be filled in for you.
To learn about the main criteria most brokerages will need to get you started trading options and to review a list of our recommended brokers, click here.
There you have it... everything you need to make money in options. And remember: Big winners make small bets.