Option Trading Basics
Using options is, in my opinion, the BEST way to trade. Why? The answer is found in their name, OPTIONS. By trading options, we give ourselves many ways to profit with low risk.
We can turn a losing position into a winning position. We can amplify wins and minimize losses. We can limit risk and create income. We can make money whether a stock or index goes up, down or stays right where it is at even over a long period of time.
A little further down we will share a trade we did which spanned 11.5 months, in which we had minimal rick and yet it yielded $11,185.27 profit with $10,800 at rick. Before we tell you about that trade let's get some of the basics out of the way.
What are options?
An option is a contract which gives the owner the right, but not the obligation, to buy or sell an underlying asset at a specified (strike) price on or before (expiration) a specified date. Option contracts are bought and sold in 100 share blocks. So if you sell 1 option contract you are actually selling on option on 100 shares.
There are only two types of options, puts and calls.
What is a put option?
If we sell a put option (which is what I typically do) then we are giving the buyer of that option the right but not the obligation to sell their stock to us, the put option seller, at the set strike price before expiration of the option. In order to do this, they pay us a premium or money.
What is a call option?
If we sell a call option (which I promote) then we are giving the buyer the right, but not the obligation to buy our stock at the set strike price anytime before expiration of the option. In order to have this right, they pay us a premium or money.
How are option sell prices determined?
There are five factors that go into the pricing of an option. It is NOT vital that we remember all five but it is important that we know what some of these five factors are. They are:
Of these 5 factors, we are most concerned with Theta, Delta and Vega.
Using options is, in my opinion, the BEST way to trade. Why? The answer is found in their name, OPTIONS. By trading options, we give ourselves many ways to profit with low risk.
We can turn a losing position into a winning position. We can amplify wins and minimize losses. We can limit risk and create income. We can make money whether a stock or index goes up, down or stays right where it is at even over a long period of time.
A little further down we will share a trade we did which spanned 11.5 months, in which we had minimal rick and yet it yielded $11,185.27 profit with $10,800 at rick. Before we tell you about that trade let's get some of the basics out of the way.
What are options?
An option is a contract which gives the owner the right, but not the obligation, to buy or sell an underlying asset at a specified (strike) price on or before (expiration) a specified date. Option contracts are bought and sold in 100 share blocks. So if you sell 1 option contract you are actually selling on option on 100 shares.
There are only two types of options, puts and calls.
What is a put option?
If we sell a put option (which is what I typically do) then we are giving the buyer of that option the right but not the obligation to sell their stock to us, the put option seller, at the set strike price before expiration of the option. In order to do this, they pay us a premium or money.
What is a call option?
If we sell a call option (which I promote) then we are giving the buyer the right, but not the obligation to buy our stock at the set strike price anytime before expiration of the option. In order to have this right, they pay us a premium or money.
How are option sell prices determined?
There are five factors that go into the pricing of an option. It is NOT vital that we remember all five but it is important that we know what some of these five factors are. They are:
- Delta - The amount an option's price will change for a corresponding one-point change in the price of the underlying security.
- Gamma - The rate of change of the delta for a small change in the price of the underlying asset.
- Theta - The rate of change of the options value as time (usually 1 day at a time) passes with all else remaining the same.
- Vega - The rate of change of the options value with respect to the 1% change in the volatility.
- Rho - The rate of change of the options value with respect to the 1% change in interest rate.
Of these 5 factors, we are most concerned with Theta, Delta and Vega.
Let's break this down using a real stock and option that I am trading right now. AMZN or Amazon puts with a June 22nd expiration (47 days until expiration) are currently selling for $14.45. Here are the estimated values (shown in per day or per unit) of the 5 factors for this option:
- Delta .3688
- Gamma .0075
- Theta .2040
- Vega .3535
- Rho .131
Let's calculate how much we would make in 1 day using the factors above for AMAZ. If all things remained equal, the option we sold would lose $0.2040 in value per day per share on day 1. Therefore $0.2040 X 100 shares = $20.40.
This tells us that by selling 1 put contract (100 shares) June expiration 250 strike on AMZN, if volatility, interest rates and price remained the same, we would make $20.40 on day one in option premium decay.
As expiration day gets closer, time decay accelerates and the option decays more rapidly, so it decays a greater percent today then it did yesterday, all other factors being equal.
For example, it is estimated that time decay will decrease the value of the AMZN $250 put by $0.2040 today, but tomorrow the decay will be $0.2061 per share. The day of expiration, or when there is only 1 day left until expiration, theta is estimated to be $0.3879 per share, so the position will lose $38.79 over the last 24 hours of the options life.
Three of the factors change daily, some of them even every minute, but typically these changes are smaller. Volatility and price (vega, gamma and delta) are the factors that can change and even change drastically sometimes.
How can we buy stocks at a discount and earn income from selling put options while doing so?
Let's say you are interested in buying 100 shares of Amazon. Currently it is trading at $258.98. What if you only wanted to pay $250 for it, how could you do that and get paid for it?
By selling the $250 put option, which is currently paying $14.45 per share, or $1,445 we are agreeing to buy 100 shares of Amazon stock at $250 per share if the stock closes below $250 on June option expiration day, forty seven days from now.
If the stock is higher then $250, on option expiration day, which is the third Friday of every month, or forty seven days from now, then we get to keep the entire $1,445, no strings attached.
That is a 5.8% cash on cash return in 47 days. If you figure the typical margin requirement (typically 20% of strike price plus a few other smaller amounts), the return would be a 28.9% return in 47 days. Annualized that would be a return of 44.9% and 224% respectively! The stock could stay where it is at, got up or even go down 3.48% and you would still net this return.
If on the other hand, the stock goes down and closes below $250 by option expiration day, the third Friday in June, forty seven days from now, then we will purchase 100 shares of Amazon at $250 per share. If you did not want to purchase the stock we could always roll the put option we sold, over to the next month.
To do this we would buy back the one we sold for this month and sell the put option for the next month. There are several options we have available to us as option traders when deciding exactly how to roll this option out to the next month.
Keep in mind though that we have already pocketed $1,445 or $14.45 per share. So our actual cost would be more like:
$250 per share --> (purchase price)
- $14.45 per share --> (received for selling put option)
= $235.55 per share--> (Actual out of pocket cost)
This means we purchased the stock at a 5.78% discount, not to mention we purchased it 3.47% lower then it was on the day we decided to purchase the stock. All together we purchased the stock at a 9.25% discount! That should have us smiling very big!
This is done by investors in the know every day. I have done this thousands of times. You can do it also.
How can we make money once we buy the stock at $250? This is done by selling a call option against the stock we own.
How can I get income from selling call options?
Here is an example of the income we could receive by selling call options against a stock portfolio we currently own:
Call Days Option
Stock # Of Price Strike Strike Option Till Income Called Current
Symbol Shares Quote Date Price Premium Exp /Month Value Value
-------- ------- ----------- ------------- -------- ---------- -------- -------- -------- --------
ATVI 1400 $15.18 06/21/13 $16.00 $0.34 49 $291 $22400 $21252
GOOG 100 $845.72 05/24/13 $850.00 $12.00 21 $1714 $85000 $84572
GLD 200 $142.09 05/24/13 $142.50 $2.34 21 $669 $28500 $28418
NFLX 100 $213.45 05/24/13 $215.00 $7.10 21 $1014 $21500 $21345
UYG 300 $89.56 06/21/13 $90.00 $3.10 49 $569 $27000 $26868
OIH 500 $43.58 06/21/13 $44.00 $1.15 49 $352 $22000 $21790
AMZN 100 $58.05 05/24/13 $260.00 $5.25 21 $750 $26000 $25805
AAPL 100 $449.98 05/24/13 $450.00 $9.05 21 $1293 $45000 $44998
BIDU 300 $84.51 05/24/13 $85.00 $2.01 21 $861 $25500 $25353
ERX 400 $65.51 06/21/13 $66.00 $4.10 49 $1004 $26400 $26204
TOTAL/AVG 32 $8,518 $329,300 $326,605
Potential Capital Gain $2,695 or 0.83% of Portfolio
Potential Yearly Income $102,220 or 31.30% of Portfolio
If we owned the list of stocks above, and sold call options against those stocks, we could receive $8,518 for those options immediately! That is cash in our account that we can set aside, pull out and spend, live on, buy more stock, buy safer conservative investments or anything else we want to use it on. How nice it is to know how to profit from options!
These are the kinds of returns option traders receive every day.
Expiration day - After selling PUT options
So we have discussed what options are, how they are priced, and we have seen examples of how much income they can generate for us. Now we will look at how to handle options expiration day. We have already discussed selling options for the first time, but what will happen at the expiration date?
Let's continue with our AMZN example. If AMZN is above the $250 price on options expiration date (the 3rd Friday of EVERY month), or June 22nd, then we do not need to do anything! The option will expire worthless.
What happens if AMZN is below $250 at the end of expiration day? If we do nothing, then the stock will be sold to us. If we do NOT want to own the stock, we can either buy the option back and this will close out the position, OR we could "roll" the option over to the next month. This simply involves buying the $250 June option that we sold 47 days ago, and selling the July $250 strike option in its place. But that is not the only option we have at this point.
Here is were the term "options" really can help us. What if AMZN has dropped to $245? We would buy the June $250 option back for approximately $5.00 per share and we could either sell the July $250 put for $9.74 thus giving us a $4.74 per share credit (cash) for the trade OR to give us some room for the price drop, we could actually sell a lower strike and still take in a small credit.
We could sell the July $245 put for $7.12 per share or we could sell the July $240 for $5.25 and both of these choices would yield us a credit or cash into our account while absorbing, AT NO COST TO US, the price decline that AMZN experienced!
Let's make sure we understand what is happening here. If you need to re-read this section do it as many times as it takes because this is VERY important in understanding how options can give you very nice income and yet plenty of protection in case we are wrong in our market direction.
AMZN dropped from $258.98 down to $245 and we are still making a very nice profit. We pocketed $14.45 in May. Now we are pocketing more in July. If we roll the strike price for July down to $240 the stock can drop $5.00 more before it hits our strike price. We only pocketed $0.25 per share but we got $5.00 more in cushion! If that happens, it means that AMZN will have dropped $18.98 or 7.3% in 47 days (which means the direction moved against us) and yet we STILL have a PROFIT of $14.70 per share!
If we chose to sell the $245 strike, then we will pocket $2.12 per share after the cost of buying the June $250 strike back for $5.00. How NICE it is to have options!!
If on the other hand we feel good about buying AMZN at $250 then we could just let the put option get assigned to us. By Monday we will have 100 shares of AMZN in our account and we will have paid $250 per share for it.
Do not forget though that we pocked $14.45 per share initially. So we will have a very nice chunk of cash in our account. Now that we own the stock, we can sell call options against it for immediate income as we discussed earlier.
This is real stuff! And it can put REAL money in our pockets starting today!
EXPIRATION DAY - AFTER SELLING CALL OPTIONS
What happens once we bought AMZN and then sold call options against our stock? Well let's continue with our example. To recap, we sold a June put option at $250, the stock dropped to $250 and we were assigned 100 shares of AMZN at $250.
We then sold July $250 call options against our 100 shares for which we should have pockets around $7.06 per share or $706 minus commission. It is now July 20th, options expiration day. Let's go thru the 2 possible scenarios:
IF AMZN IS TRADING ABOVE $250
If AMZN is trading below $250 then the call option we sold will expire worthless and we can sell another call option for August.
If AMZN is trading above $250 and we do nothing, then the 100 shares will be called away from us and we will be back in an all cash position. No stock and no options but we will have kept ALL our option premium that was paid to us over the last several months for the puts AND calls we sold.
ANOTHER OPTION we have as option traders if AMZN is trading above $250 and we want to keep the stock is to roll the call option that we sold with the July expiration over to August. We can even roll the option to August and UP to a higher strike price. Why would we do that? Well maybe we feel that AMZN will continue to go up and we want to capture some of that stock increase.
Let's say AMZN has gone up to $256 by expiration day in July. Here is what our overall situation will look like:
Sold June 25th $250 put - $14.45 per share X 100 shares = $1,445 cash in our account
On June 22nd bought 100 shares @ $250 per share
On June 25th sold July $250 calls against our shares - pocketed $7.06 per share X 100 shares = $706 cash in our account
So within 2 months, we had pocketed $2,151 on a $25,000 investment. That is a 51.6% return annualized!
NOW it is July 20th and the stock has risen to $256. IF we decide that we wanted to keep the stock, NO PROBLEM. We simply buy back the July $250 call we sold and either sell the August $250 call, or if we want to get some of that stock price increase, we sell the $255 call.
The August $255 call is selling for $7.50. So we will use $6 of that to buy back the June $250 call and we get to pocket $1.50 per share AND keep the $5 per share that the stock has increased in value!!! This would make our total profit on AMZN $2,801 in two months or 67.2% annualized return!
Using options to trade the markets in in my opinion the only way to trade. They provide us income no matter which direction the market moves in, protection against adverse moves, the ability for us to get the direction completely wrong and STILL be profitable, options to adjust our positions monthly, quarterly or annually. Indeed trading with options is the ultimate tolls that EVERY trader should have in their arsenal!
As promised, below you will find 2 bonus features. One is how to buy stock at half price. The second is a little know way to trade options that provide tremendous protection from up and down moves in the market and yet it can yield tremendous cash every month.
Let's begin with buying stock at half price. This can be done by purchasing DITM LEAPS. This stands for Deep In the Money Long Term Equity Participation Securities. Put simply, they are long term options.
Remember above we sold options that expired within 28-50 days? Well LEAPS expire longer into the future usually several years in the future.
Let's look at an example. Right now Yahoo Inc stock is trading for $26.33. The LEAP for YHOO expiration January 17, 2015 at the $15 strike price is selling for around $12.00. What would buying that LEAP call option enable us to do?
By purchasing the Jan 2015 $15 call option, it enables us to take advantage of the price movement of YHOO while not exposing us to the entire $26.33 stock price. We literally have less then half of the current stock price at risk. These DITM LEAP move very similar to the actual stock.
With YHOO stock trading at $26.33, for every dollar the stock goes up or down, the value of our DITM LEAP will move approximately 92.75% of that movement. One benefit of stock ownership that we miss out on would be dividends.
But for less then half the cost of the actual stock we receive ALMOST all the benefit of stock movement. Why would we ever pay full price for a stock when we can buy a LEAP? The extra money left over could be used to hedge your positions, hold as cash, invest in low risk assets or any other use we may have for it.
How can we use these LEAPS to protect us further and produce monthly cash? The second bonus I promised will explain this.
Using CONDOR's for protection and income generation.
First we need to define 2 terms:
Option spreads and CONDOR.
An option spread is created by buying and selling an equal number of options of the same underlying security with different strikes prices and or expiration dates.
For example using the YHOO example above, we might buy a LEAP Jan 2015 call at the $15 strike and sell next months $15 strike call option against the one we bought. Or we could buy the Jan 2015 put at the $15 strike and sell next months $15 strike put option against the one we bought.
The condor is an advanced option trading strategy that is comprised of two spreads - a put and a call spread.
The way we trade these are to buy what is call LEAPS (Long Term Equity Participation Securities) that expire years in the future and sell near term (30-60 day expiration) options against them. Please re-read this section as many times as needed to understand this.
Let's look at an example of CONDOR trading that we did in YAHOO from November 9, 2011 thru October 22, 2012.
If a trader had bought YHOO on November 9, 2011 they would have paid $16.17 per share. If they held it until October 22, 2012 they would have sold it for $15.77. So they would have realized a $0.40 per share loss.
Let's see how we did with this same stock using a condor option spread. By selling near term expiration put and call options against LEAPS we had purchased we were able to generated $11,185.27 in profit in 11.5 months while risking less then $10,800.
I say $10,800 because that was the overall purchase price of the LEAPS but actually only half of that was at risk because we purchased LEAP calls with half that amount and LEAP puts with the other half. Therefore, if the YHOO dropped, although the calls we bought would lose value, the puts we bought would gain value and vice verse.
So we truly only had $5,400 at risk at a time, or you might say we had even less then that at risk since a loss on one side would generate a profit on the other side. So how did we generate $11,185.27 in profit over an 11.5 month time frame with less then $5,400 at risk?
By selling call and put options against the long LEAP options we owned. Here is what that looked like:
On November 9, 2011, we purchased 17 contracts of the $15.00 Jan 18, 2014 call AND put options. Simultaneously, we sold short 17 contracts of near month call and put options against the long options we just bought. So our account looked like this:
PURCHASED (LEAP) long calls and puts Jan 2014 expiration: ($10,836.73) includes commission
SOLD calls and puts expiring in November 2011 + $2,698.16 includes commission
NET cash at end of Month 1 ------------------------------->> = $8,138.57
Month 2
Purchased contracts back that we sold on Nov 9 and sold calls and puts with December expiration.
Yielded a net increase in cash of + $2,661.93 after commission
Month 3 + $2,457.04 after commission
Month 4 + $242.52 after commission
Month 5 + $2,075.92 after commission
Month 6 + $647.85 after commission
Month 7 + $576.19 after commission
Month 8 + $1,664.20 after commission
Month 9 + $672.95 after commission
Month 10 + $889.56 after commission
Month 11 + $73.01 after commission
Month 12 (closed position mid way thru month) + $284.34 after commission
Month 12 (sold LEAPS) + $7,078.33
NET + $11,185.27
I continued this process of closing out expiration options by buying them back or letting them expire worthless and selling the next months options until I felt that YHOO was going to break out of the range bound area it had been trading in. At that point on October 22, 2012 I closed out the entire position.
In order to do this, I sold my long positions (LEAP call and put options) for $7,078.33 yielding a loss on them of ($3,758.40) BUT during that time I sold near month calls and puts against them for a profit of $14,943.67 thus yielding an overall profit of $11,185.27. That equates to an annual return of 103.57% if you use a $10,800 base.
Remember though that we immediately sold near month calls and puts which paid us $2,439.24 against our LEAPS purchase so we were actually only out of pocket $8,397.49. This makes our return 133.20% annualized!
These are the kinds of trades you can do with condor options. This position, like any position needs to be monitored and it is an advanced strategy, but I wanted to give you an example of the kinds of returns you can get with a relatively low risk trade using options.
If you buy a stock you can ONLY make money if the stock price goes up and or a dividend is received. If you short the stock you can ONLY make money if the stock goes down. In options, there are numerous ways to make money and they are NOT limited to price movement.
In this report we have discussed a lot of terms and several strategies available to option traders. I understand that this can be confusing to a new and possibly even and experienced trader. Therefore I am offering to you the opportunity to drastically decrease your learning curve by spending time with you one-on-one.
We offer private training specifically focused on your goals and needs. We can help you set up your account (be careful which trading brokers you use as commission vary greatly from one broker to the next), make your 1st trade or your 1,000th trade.
We offer this service at $500 per hour for zoom/phone calls and $450 per hour for email coaching. To purchase one of these training sessions please email me at rpproperties1@aol.com
HAPPY INVESTING!