Why trade options? If you have the skill (or luck) to know when a stock is going to move higher or lower, why not just buy or short the shares? The same can be said for commodities – why trade options when you can trade futures contracts?
Too many people look at options as tools for speculation. Sure, options provide leverage, giving you the possibility of turning a few hundred dollars into several thousand dollars. And yes, that possibility is attractive. But do you play the lottery – just because the prize is huge? Everyone knows the lottery is a bad bet and that the chances of winning are terrible.
But options cost more than lottery tickets and the payoff is smaller. The probability of success is small because so much must go your way when you buy options: price change, timing of that change, size of the change. It’s a tough road.
Options were not designed as tools for speculation, and if you want to get the most out of options, consider using them as they were designed – as risk-reducing investment tools.
Options, when used properly, allow an investor to reduce risk and provide an improved chance to profit from stock market investments.
First, it’s necessary to understand the basic principles behind options trading. It is important to understand how options work before you consider trading them. Let’s dive in.
Options Trading Beginner Points
Here’s what new investors need to know about options:
- An option is an agreement, or contract, between two parties: a buyer and a seller.
- Exchange traded option contracts are guaranteed by the Options Clearing Corporation (OCC). There has never been a default in the 40+ year history of the OCC.
- There are two types of options: calls and puts.
- The option buyer pays a premium to the seller.
- In return for receiving the premium, the seller grants specific rights to the buyer and accepts specific obligations.
- A call option grants its owner the right to buy a specific item (contract) at a specified price (called the strike price) for a limited time.
- A put option grants its owner the right to sell a specific item (contract) at the strike price for a limited time.
- Each contract represents 100 shares of stock. The generic name is the, “underlying asset.”
- The limited time ends on the option expiration date. Equity options expire on the third Friday of the month, after the market closes for trading (technically expiration is the following morning, but the last time you may sell or exercise an option is the third Friday).
- An option seller may become obligated to honor the conditions of the contract – i.e., sell stock to the call owner or buy stock from the put owner. If the option expires worthless, then the option seller is relieved of his/her obligations.
As the owner of the option, you can either A. sell it on the open market like you would shares, B. you can exercise it, or C. Allow it to become worthless (if expiration day arrives and the option has neither been sold, nor exercised, it expires worthless).
Exercising is the process by which an option owner does what the contract allows. Thus, a call owner can exercise the option, and buy 100 shares of the specified stock at the strike price per share – as long as the option has not yet expired. A put owner may sell 100 shares at the strike price. In practice, it’s more efficient to sell an option, rather than exercise.
Options Versus Stocks Differences
While obvious, it is important to emphasize: options are not stocks. With stocks, you are holding shares or ownership in a company. Contrarily, options are time restricted contracts that represent shares (100 shares per contract).
Option prices depend on far more than supply and demand. When markets are generally calm, option prices tend to decrease. When markets are volatile, option prices tend to increase. And that’s true for puts and calls.
Here are the three most important differences between stocks and options:
- Options expire while stock shares last forever (unless the company goes bankrupt or gets acquired).
- Options are derivative products. Their value is derived from the value of another asset. Stocks are assets, and have an intrinsic value based on the company they represent.
- Option owners have rights, but do not own anything tangible. Stock owners are entitled to dividends and own a voting share of the company.
Reasons to Trade Options
If you are a typical stock market investor, you adopted a buy and hold philosophy and own stocks, ETFs, or mutual funds. If you are a hands-on investor, you likely do research and carefully select stocks to buy. It’s difficult to beat the market, and most professional money managers underperform.
Investors tend to be long. They own stocks. They don’t know how to hedge, or reduce the risk of owning, investments. That’s why options are so important. To me, it’s unfortunate that so few brokers help clients to adopt risk-reducing strategies with options.
Here are seven great reasons why you should take time to learn how options work:
- Hedging – Options allow you to reduce the risk of investing in the stock market. Imagine how investors everywhere would feel if they learned that the giant losses they suffered were unnecessary. By using appropriate hedging strategies, losses can be reduced significantly.
- Insurance – You can buy insurance that protects the value of your portfolio – just as you buy insurance to protect the value of your home or car. Using options, there are strategies that allow you to own insurance for little, or no, cost.
- Income – By selling someone else the right to buy your stock at a predetermined price (selling a call option), you are paid a premium that you can consider to be a special dividend.
- Leverage – With options, you have the ability to avoid trading shares of stock altogether. Options also allow you to take a position with far less capital invested than buying shares outright.
- No Need to Always Be Bullish – Options allow you to create positions that prosper when the market moves higher, lower, or trades in a range. Traditional long investors only profit when stocks move higher.
- Limited risk – You can adopt strategies with limited loss, but with high probability of success. The trade off is that profits are also limited. The limited loss nature of so many option strategies is one important factor that makes them so attractive.
- Indexing – If you prefer to trade a diversified portfolio rather than individual stocks, the major indexes (e.g., S&P 500, DJIA, Russell 2000, etc) have options you can trade.
Basic Types of Options Trades
Beginner options traders often get stuck when entering an order because they have not yet learned which of the four choices applies.
When you trade options, there are four ways in which each trade can be described:
Buy to Open
A. An order to buy a specific option
B. You are initiating a new position, or increasing an existing position
Buy to Close
A. An order to buy a specific option
B. You are buying an option that you previously sold
C. You are reducing or exiting (closing) an existing position
Sell to Open
A. An order to sell a specific option
B. You are writing (selling) an option you do not own
C. You are initiating a new position, or increasing an existing position
Sell to Close
A. An order to sell a specific option
B. You are selling an option you bought earlier
C. You are reducing or exiting an existing position
Note: When you trade options spreads (multiple options contracts in combination), you are entering an order to trade at least two different options simultaneously. When you initiate the trade, the appropriate boxes to check are: ‘Buy to open’ for the option you buy and ‘sell to open’ for the option you sell.
Some online brokers require that you specify into which of the four categories your trade falls. Others don’t ask because it’s a simple matter for their computers to gather the information.
Popular Options Trading Strategies
Option rookies are often eager to begin trading – too eager. It’s important to get a solid foundation to be certain you understand how options work and how they can help you achieve your goals – before trading.
Here’s a list of my favorite methods. Note: this list contains strategies that are easy to learn and understand. Each is less risky than owning stock. Most involve limited risk. For investors not familiar with options lingo read our beginners options terms and intermediate options terms posts.
1. Writing covered calls
Using stock you already own (or buy new shares), you sell someone else a call option that grants the buyer the right to buy your stock at a specified price. That limits profit potential. You collect a cash premium that is yours to keep, no matter what else happens. That cash reduces your cost. Thus, if the stock declines in price, you may incur a loss, but you are better off than if you simply owned the shares.
Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call
2. Writing cash-secured naked puts
Sell a put option on a stock you want to own, choosing a strike price that represents the price you are willing to pay for stock. You collect a cash premium in return for accepting an obligation to buy stock by paying the strike price. You may not buy the stock, but if you don’t, you keep the premium as a consolation prize. If you maintain enough cash in your brokerage account to buy the shares (if the put owner exercises the put), then you are considered to be ‘cash-secured.’
Example: Sell one AMZN Jul 50 put; maintain $5,000 in account
A collar is a covered call position, with the addition of a put. The put acts as an insurance policy and limit losses to a minimal (but adjustable) amount. Profits are also limited, but conservative investors find that it’s a good trade-off to limit profits in return for limited losses.
Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call
Buy one IBM Jan 95 put
4. Credit spreads
The purchase of one call option, and the sale of another. Or the purchase of one put option, and the sale of another. Both options have the same expiration. It’s called a credit spread because the investor collects cash for the trade. Thus, the higher priced option is sold, and a less expensive, further out of the money option is bought. This strategy has a market bias (call spread is bearish and put spread is bullish) with limited profits and limited losses.
Example: Buy 5 JNJ Jul 60 calls
Sell 5 JNJ Jul 55 calls
or Buy 5 SPY Apr 78 puts
Sell 5 SPY Apr 80 puts
5. Iron condors
A position that consists of one call credit spread and one put credit spread. Again, gains and losses are limited.
Example: Buy 2 SPX May 880 calls
Sell 2 SPX May 860 calls
and Buy 2 SPX May 740 puts
Sell 2 SPX May 760 puts
6. Diagonal (or double diagonal) spreads
These are spreads in which the options have different strike prices and different expiration dates.
1. The option bought expires later than the option sold
2. The option bought is further out of the money than the option sold
Example: Buy 7 XOM Nov 80 calls
Sell 7 XOM Oct 75 calls This is a diagonal spread
Or Buy 7 XOM Nov 60 puts
Sell 7 XOM Oct 65 puts This is a diagonal spread
If you own both positions at the same time, it’s a double diagonal spread
What about buying naked calls or puts?
Note that buying calls or puts is NOT on this list, despite the fact that the majority of rookies begin their option trading careers by adopting that strategy. True, it’s fun to buy an option and treat it as a mini-lottery ticket. But, that’s gambling. The likelihood of consistently making money when buying naked options is very small, and it’s not a strategy I endorse.
How to Value Options
While stock prices depend primarily on supply and demand (buyers versus sellers), option prices depend on many factors, each of which affects the price of an option in the marketplace. Here are some of the most important factors:
1. Price of the underlying
If you own a call option, you have the right to buy stock at a specific price (strike price). For example, if you own one Nov 40 call, you can buy 100 shares at $40 per share. Wouldn’t you pay more to own that call if the stock is $39 than if it’s $35? Would you pay even more if the stock price is $43? I hope you replied ‘yes.’ That’s why calls are worth more as the stock rises.
2. Option type
A call gives you the right to buy shares and a put gives you the right to sell shares. Thus you cannot expect put and call prices to move in tandem. When the stock moves higher, call options increase in value and put options decrease in value.
3. Time to Expiration
When you own an option, you want to see the stock move higher (call option) or lower (put option). The more time that remains before an option expires, the greater the chance that a favorable more will occur. Thus, more time makes all options more valuable. It’s true that more time allows the stock to make an unfavorable move, but that’s not the significant factor in determining a price of an option. It’s the potential payoff, and the probability of receiving that payoff, that determines an option’s value.
4. Interest Rates
Call options can be used as an alternative to owning stock. When you buy stock, you must use cash, and that cash could be invested to earn interest. Thus, the more interest you earn on your cash, the more you should be willing to pay for a call option. This is not a significant factor in determining an option’s value.
5. Strike Price
When you buy stock, you want to pay the lowest possible price. Thus, the right to buy stock at $25 per share is more valuable than the right to buy stock at $30 per share. For that reason, call options increase in value as the strike price decreases.
When selling stock, you want to receive the highest possible price. Thus, it’s more valuable to own the right to sell shares at $60 than the right to sell shares at $55. Puts are worth more as the strike price increases.
When a stock pays a dividend, its price declines by the amount of that dividend. That occurs when the stock ‘goes ex-dividend’ (the buyer is not entitled to receive the dividend). The higher the dividend, the more the price declines. Because a lower stock price is not good for the call owner, as the dividend increases, the value of a call option decreases. Similarly, the value of a put option increases.
These options do not suddenly change price when the stock goes ex-dividend. The model (modified Black-Scholes) that determines the fair value of an option ‘knows’ that the stock has a dividend in its future, and the effect of that dividend is already priced into the option when you buy or sell it.
This is the crucial factor in determining the price of an option. Each of the other factors involved in an option’s price is known with certainty. But the volatility estimate used to calculate the value of an option refers to the future volatility. Specifically: how volatile is the stock going to be between the time the option is purchased and the time it expires? Because the future is unknown, the volatility component of an option’s price can only be estimated. Different people make different estimates, and thus, each has a different idea as to the value of an option. If you notice options changing price when the stock doesn’t move (or vice versa) it’s likely due to a change in the volatility estimate.
To provide even more clarity here, when you own an option, you want the stock price to change by a large amount because when the stock moves far beyond the strike, the value of your option increases. When stocks are not very volatile and undergo daily price changes of just a few pennies, a big move is unlikely. But when the stock price frequently changes by 5% in a single day, a few of those moves in the same direction can provide a handsome profit. Thus, the options of more volatile stocks are worth a great deal more than options of non-volatile stocks.
When dealing with options, it’s possible to measure and modify the risk of any stock market investment. You can take steps you deem necessary to offset as little, or as much, of that risk as desired. When calculating various risks, a set of Greek letters, collectively known as ‘the Greeks,’ are used to measure (or quantify) specific risks associated with an investment.
Let’s take a quick look at a few of the more important, and commonly used, Greeks: delta, gamma, theta, and vega. NOTE: Vega is not a Greek letter, but apparently that’s not an issue.
- Delta measures the rate at which the price of an option changes when the underlying asset (stock, ETF or index) moves one point. Delta is not constant.
- Gamma measure the rate at which delta changes as the underlying moves one point.
- Theta measures the amount by which the value of an option decreases as one day passes. Thus, theta is ‘time decay.’
- Vega measures the sensitivity of the option’s price to a change in the implied volatility (IV), and represents the amount by which the option value changes when IV moves higher or lower by one point.
By calculating the delta, gamma, theta and vega of a position, specific risk parameters are measured, and thus, can be adjusted to suit the risk tolerance of the investor. And don’t worry, every online broker will calculate the Greeks for you.
How to Read an Option Chain
It’s good to understand specific option strategies and the reasons for adopting them, but for true rookies, something else is needed – and that’s an understanding of how to read an option chain to place a trade. Each broker has its individual trading platform, but if you learn to use one platform, the general principles should transfer to another.
Let’s look at a typical option chain from the Chicago Board Options Exchange (CBOE). Below is information for some IBM options.
1. Calls. This is a (partial) list of call options that are listed for trading at the various options exchanges. The next six columns refer to specific call options.
- The first row contains: “09 Apr 90.00 IBM (IBM DR – E)”
- “09” refers to the year in which the option expires, or 2009
- “Apr” is the expiration month. For all options on individual stocks, expiration day is Saturday, one day after the 3rd Friday
- “90.00” is the strike price, or the price at which the owner of this call option has the right to buy 100 shares of IBM. It is customary to ignore the decimals when they are ‘00’
- “IBM” is the ticker symbol for the underlying stock
- “IBM DR” is the symbol that describes the specific option. “D” represents the expiration month (April). “R” represents the strike price (90). The last letter is not part of the symbol. It’s used to designate the exchange from which market data is taken, and “E” stands for CBOE
2. Last sale. The most recent price at which the option traded. This number is seldom useful because you cannot tell whether the last trade occurred 5 seconds or 5 hours ago.
3. Net. This column shows today’s price change. It’s the difference between the last price and yesterday’s last price. This column serves no practical purpose. Red numbers indicate today’s price is lower, and green means higher.
4. Bid. The highest advertised price anyone is willing to pay for this option at this time. Be aware that the ‘real’ bid is often not published and that there’s a reasonable chance you can sell the option at a higher price.
5. Ask. The lowest advertised price that anyone is willing to accept when selling this option at this time. Be aware that the ‘real’ ask price is often not published and that there’s a chance you can buy the option at a lower price. When the bid/ask spread is wide, the chances of obtaining a better price (when you enter an order) are excellent.
6. Vol. (Volume) The number of option contracts that traded today on this exchange. If no exchange is specified, then it’s the total volume on all exchanges.
7. Open Int. (Open Interest) The total number of this specific option that exists. In other words, the open interest equals the number of options written (sold) that have not yet been bought back or exercised. This number is not ‘live’ and is published once per day, prior to the opening. Notice that the open interest tends to be highest for options whose strike price is nearest the stock price.
8. Puts. The same data is repeated for the put options.
- Note: The option symbol has one major difference: The letter used to represent the expiration month is not the same as the letter used to represent the call expiration month. That’s convenient because you can determine whether an option is a call or put by its symbol. The letters A to L represent Jan thru December for calls. The letters M to X represent Jan thru Dec for puts. Thus, the first row contains the IBM Apr 90 put, symbol IBM PR. Where P = April expiration for puts
- The letter representing the strike price is the same for calls and puts. IBM PR is the IBM put, expiring in Apr, strike price 90.
Your First Options Trade: Writing a Covered Call
If you are an investor who has experience buying and selling stocks, then it should be easy for you to make the transition to writing covered calls. Why? Because this option strategy begins with the purchase of stock – and you are already familiar with that process and the decisions required.
Writing covered calls is neither the best nor safest strategy available, but it’s safer than owning stocks outright and it gives you experience using options. Writing a basic covered call is my recommended first option trades.
Here are three reasons why writing covered calls makes sense as an introduction to the world of options:
Covered calls are an easy to understand strategy.
- You sell someone else the right to buy your stock at a specified price (strike price)
- You collect cash for making that sale
- The agreement has a limited lifetime
- If the other person declines to buy your stock by the deadline, the agreement expires and you are no longer obligated to sell your shares.
Covered Calls can lead to many more profitable trades when compared with buying stock.
- If the stock declines, you lose less than the person who did not write a covered call.
- If the stock declines by less than the premium you collected, you earn a profit.
- If the stock is relatively unchanged when expiration day arrives, you have a profit while the buy and hold investor breaks even.
- If the stock moves beyond the strike price by less than the premium collected, you earn more than the buy and hold investor.
- If the stock undergoes a significant price increase, that’s the only scenario in which you earn less than the buy and hold investor
Bottom line, covered calls provide options traders more frequent profits and overall reduce risk. By collecting cash for selling the call, you are effectively reducing your cost basis for the shares of stock you own. Thus, covered calls do not remove risk altogether, but they do reduce risk from holding shares long without any protection.
9 Easy Tips for Option Trading Success
Most investors who are looking for ‘tips’ for option trading success have the wrong perspective. They seek tricks, special strategies, or ‘can’t-miss’ gimmicks. There are no such things.
Options are the best investment vehicles around. They allow investors to take long, short, or neutral positions. They allow you to manage risk far better than any other investment method. Use them wisely and they will treat you well.
Here are nine easy tips for new options traders to follow if they want to be successful:
1. Options are best used as risk-reducing investment tools, not instruments for gambling.
2. Use the options Greeks to measure risk.
3. Manage risk carefully. Do not hold any position than can – in the worst case scenario – cost more than you are willing to lose.
4. Be careful about the number of option contracts you trade. It’s easy to over-trade with inexpensive option contracts – especially when selling.
5. Don’t go broke. Never allow an unexpected event to wipe out your account.
6. Do not expect miracles. Do not buy options that are far out of the money just because they are ‘cheap.’ The chances of success are tiny. Not zero, just tiny.
7. Selling naked options is less risky than buying stock. But, like stock ownership, there is considerable downside risk. Exception: It’s reasonable to sell naked puts – but only if you want to buy the shares, if assigned an exercise notice.
8. Limit losses. The most effective way to accomplish that is to buy one option for every option you sell. That means selling spreads, rather than naked options.
9. Hope is not a strategy. When a position goes bad, consider reducing risk. Doing nothing and hoping for a good outcome is nothing more than gambling.
Additional Options Resources
To wrap this guide up, here is a list of excellent articles across the web to help you learn options trading and trade successfully:
- Best Brokers for Options Trading
- Buy my book, The Rookie’s Guide to Options. Ok, shameless plug! Here’s another great options book, The Options Playbook
- Covered calls strategy and examples
- Essential Options Trading Guide
- What Is Option Trading? 8 Things to Know Before You Trade
- 5 Simple Options Trading Strategies
- 10 Great Ways to Learn Stock Trading
- 5 Best Online Stock Brokers
- 20 Must Read Investment Books
- 5 Best Free Stock Chart Websites
- 10 Trading Secrets I Wish I Knew When I Got Started