In this post, “How to Make Money Trading Options” I’m going to attempt to teach you how to use options to increase your income and to hedge against any loses is your stock portfolio.in your portfolio.
Options are an amazing vehicle for investors to use to maximise their returns when trading stocks while controlling their risks.
But first a…
DISCLAIMER: This post has been written for infotainment purposes and any actions take as a result of the material contain here in are your responsibility solely. this does not constitute as financial advice.
OK….
What Are Options
Options are financial instruments that were created to offer financial protection to investors.
These financial instruments have been around for thousands of years.
Yes…
The Greeks first used them to speculate all of their harvests.
Now…
In this day and age options are most commonly used in conjunction with equities, such as shares or a company’s common stock but there are many different type so options some of which include:
The majority of the worlds options are traded in Chicago, USA.
So..
Here’s a definition of an option…
An option offers the buyer the right to buy or sell the underlying financial instrument at a specific price and on a specific date , without constraining the investor with an obligation to do either.
When an option is traded – it is either bought or sold.
The buyer has rights and the seller has obligations.
The buyer pays a premium to the seller in every transaction, so the seller will receive the premium which is why they have obligations.
So…
Why use options in the first place?
Here are some advantages of options trading over stock trading;
- You can start with a smaller account
- Great for generating active short-term and passive long-term income
Remember, options were originally created to hedge against stock movement.
In reality most good company stocks can cost hundred or thousands per share.
Options provide dynamic leverage with limited and defined risk.
By having dynamic leverage and defined risk you have the flexibility to use options in all market environments – up, down or sideways.
Options used to be expensive to trade – not any more!
Anyone can trade options as long as long as they have received permission from a registered derivatives broker.
An options contract represents control of share of stock:
1 options contract = 100 shares of a stock.
Simple.
Now…
Each option has what is known as a strike price – the price of the underlying stock, that has been agreed upon my the options buyer and seller.
Options contracts also have an expiration date – the date the option can no longer be used.
All options decay in value as time passes and the closer the expiration date, the less valuable the the value of the options contract.
Earlier, I referred to the ‘premium of an option’.
A premium is really made up of two things:
- intrinsic value -real equity
- extrinsic value – time, supply and demand
Globally, the nature of options can differ significantly.
A U.S options is one that can be exercised and assigned any time before expiration.
So, let’s say it’s June and you have bought a September option contract, you can exercise at any time before September.
With European options – you can only exercise the option assigned on its expiration date.
What you normally find is that US options are normally equity based and index based options tend to be European.
How Options Work
I want you to think about an options like an insurance policy.
So…
Let’s say you are the proud owner of a truck.
You, the insurance buyer, pay your car insurance company a premium in exchange for a contract which would be your policy.
With me so far?
OK…
As an insurance buyer, that policy that you’ve paid for can be exercised anytime between the date that it was issued until the expiration date of the contract.
If you make a claim, the insurance company has an obligation and their obligated to fulfil the terms of the underlying contract.
What happens in you don’t make a claim?
The policy expires worthless and the insurance company keeps all of the premium.
So, to drive this point, let’s look at a scenario.
You’ve bought an insured a beautiful new car.
One evening, you hear the the sound of the window smashing and the screech as the car pulls away and off of your drive.
Some kids in the neighbourhood have stolen your car and subsequently crashed it into another truck leaving it totally written off.
You have been left with no choice but to exercise the ‘option’ in your insurance contract.
The seller of your contract, the insurance company, will pay the replacement value of your car as per the written contract.
Options contracts in equities work much the same way.
Now…
There are two types of options that I want you to consider:
- Call Options
- Put Options
Let’s discuss these in more detail.
Call Options
A call option is the right to buy an underlying stock at a set price on or before a set date.
So, if you are the buyer of a call option contract – you are expecting the price of the stock to go up in the future.
This is commonly referred to as bullish sentiment.
Now…
If you’re the seller of a call option, you are expecting the underlying stock to go down in price.
You sentiment will be neutral or bearish.
Put Options
A put option sis the right to sell a stock at a set price by a set date.
When you buy the put option you are hoping the price of the stock will decrease in value.
In other words, you are going to be bearish in your sentiment.
If you sell the put option, your outlook on the market and the stock is going to be neutral to bearish.
When you sell a Put option you are taking on the obligation to acquire stock.
OK, now…
A key concept that you need to understand is called settling.
Let me explain…
When you exercise a stock option, the end result or the output of the trade will be in underlying stock.
When you exercise and index option the output will be cash.
Settling refers to what you will get more or less of as a result of the trade.
Make sense?
A way to understand the nature of this better is to understand that options aren’t really an independent asset class.
They are ‘derivatives’ of another asset class such as equities.
So…
If you want more detailed information on the various categories of options products , I would recommend that you check out the CBOEs website – which will give you enough bed time reading to last you a lifettime.
But, in this post, on this site and in the weekly Sofa Salary VIP emails, I am going continue to focus on equity options.
Let’s look at…
How To Use Options
There are a few ways that you can use options to generate significant profits;
- Buy to open and Sell to close
- Sell to open – then Buy to close
So, what does this mean in English?
Remember, when I refer to options, I am referring to an options contract which needs to be opened and closed as part of a complete transaction.
If you buy a Call option to open a trading position, you need to sell the option to close the position/trade.
It’s that simple and important because your option contract needs to be closed for you to realise the return in cash or the underlying stock.
Its crucially important that you understand these concepts before we proceed so I’m going to use another one of my infamous scenarios to drill the point home.
Ready…
Scenario:
Let’s say that Freddy, has received a verbal offer to start a new delivery job, in 3 months time.
However, a condition of the job offer is that he has to own a truck.
Freddy’s challenge is that he doesn’t currently own a truck and he conveniently forgot to tell Bill his new employer that.
So…
He has 3 months to get his act together and he starts looking around for a truck at a number of dealerships.
He sees a truck that he likes but isn’t sure if he should buy it yet because his employee vetting hasn’t been completed yet so he asks the dealer if he can pay a premium for them to hold the car at the advertised price for three months.
The van costs $50,000 and the agreed premium to buy the option on his truck is an additional $5000 and the contract states that he has to buy the truck within 90 days.
Quick question…
What has Freddy received as a result of paying this premium?
Now..
Some of you might be saying, why didn’t Freddy just buy the truck for $50,000, instead of buying the truck out right.
Well, as I said earlier, Freddy has only received a verbal job offer and if his other employee vetting doesn’t come back successful, it’s highly unlikely that he will receive a formal offer for the job.
So to answer the question, Freddy has simply paid for a right to buy the truck not an obligation.
Make sense?
I know that I drive some of you mad on these points by repeating the same points over and over ad nauseam but this is how I learn new concepts and it seems to work for a lot of my subscribers too.
Apologies, I digress.
So, by paying $5000 upfront(premium) he has been able to take control the truck for a fraction of the cost it would take to buy the truck outright.
Are you with me?
OK, let’s continue.
Now..
Over the course of the 3 month period that the option contract is valid for – anything can happen.
There could be a global shortage of zinc alloy which increases the value of the car or, there could be some negative news which could reduce the value of the car.
So, let back track for a second.
Remember, Freddy was tempted to buy the truck.
He went to the dealership who is the option seller. The dealership could find another customer tomorrow and isn’t prepared to keep the car sitting around whilst Freddy makes up his mind so he is charged a premium.
The car dealer agrees terms with Freddy and they create a contract which gives him the right to buy the car at a given price over a period of three months.
So, using the crude example that I gave you earlier, if for whatever reason there was a global shortage of a key mineral that was used in production of the truck that dramatically increased its value to $80,000, Freddy would have the right to buy the car outright for the total some of $55,000.
Why $55,000?
Well, he has already paid the premium related to the contract which is $5,000 and he price of the car as stated in the contract which is $50,000.
Simple.
On the flip side…
If there was a news report that the CEO of the car manufacturer had been caught doing some illegal activity and the reputation of the company had fallen through the floor, devaluing at the value of all of its automotive products – and the value of the car fell from $50,000 to $35,000.
The worst thing that can happen to Freddy is that he loses the value of the premium because he decided not to exercise the option – he decides not to buy the truck.
I can tell that you’re getting this now if you weren’t sure before 🙂
Good stuff.
So in a nutshell, with a Call option Freddy can profit in an unlimited way if the value of the car dramatically rises but he can only lose the premium if the value goes against him.
Once again – simple.
OK, enough of the scenarios, let’s now talk about this from a stock perspective to help you to understand how this applies to the stock market.
A call option, has unlimited profit potential but it is worth noting that it also has limited risk.
So..
The call option gives the right to buy 100 shares in the underlying stock at a given time and on a given date at a fixed price.
The option seller is obliged to sell that stock if the buyer exercises the contract.
Remember…
The buyer has to exercise the contract in order for the seller to have to perform or action that contract.
The reality of trading options is that you will probably not exercise the option in the majority of cases.
When we buy a Call option the goal is normally to sell the call option.
Remember that with options contracts, you make money in one of two ways:
- Money made by exercising the option to buy ro sell stocks at a given price
- Money made based on the value of the options contract, which rises based on the change in the price of the underlying asset.
This will become clearer in future posts if you are struggling to get your heads around this concept.
So, let’s say that you love Disney stock and want to invest in the company.
The stock is currently trading at $50 a share and you are convinced that it will go up to $70 in value within the next 5 months.
You are confident but you don’t want to take the risk of paying for the stock outright.
So what you can do here is to buy the options contract.
So, if you buy a 6 months call option for $5 a share, instead of buying the stock outright you now have the ability to make money and profit from the upward movement of the stock.
The strike price here would be $50 a share. If you believe the stock will go to $60 between now and expiration, this is the window of time in which you can profit from the gain in these shares.
There are three ways that a stock can move:
- Upwards
- Sideways
- Downwards
So…
If after three months the stock goes up in price from $50 to $60 a share, the intrinsic value of the option contract would be $10 a share. This is the real value of the option.
Also, the extrinsic value of the share would be built in value of the shares.
The extrinsic value could now be $1.10.
This means that the total value of the contract would be – $10 + $.10 = $11.10 of value.
This call option only cost you $5 to begin with so you you have now made money on the options contract alone, because the stock has increased in value.
But..
What happens if the stock goes sideways.
Let’s say the stock stays at $50
This means that the intrinsic value of the stock will be $0.
Why, because the stock price hasn’t changed so there is no additional intrinsic value.
The extrinsic value could be $4 because the time decay has eroded it slightly.
In the worst case..
Let’s say that the stock goes down from $50 to $40 a share
The intrinsic value is now going to be $0.
The extrinsic value might be $1.
The value of the contract that you bought for $5 is now worth $1.
OK, I think you understand Call options now, so let’s apply the same logic to Put options.
In this scenario…
Your gut feeling tells you that a company’s stock is going to go down in price.
So, you pay the seller of the option a premium in exchange for a contract.
A contract that gives you the right and not the obligation to sell a stock at a given price and by a fixed date.
At this give you the right to sell 100 shares of the stock at a fixed price for a limited time.
So, you as the option buyer have the right to exercise the contract.
The seller has the obligation to buy the stock at a fixed price if you decide to exercise the option contract.
So, let’s say that you own 100 Apple shares.
Over the last year you are convinced that the price is about to go down soon because of a change in social trends.
What can you do to protect yourself against this loss?
What you could do here is to buy a Put option with a 9 months expiry date.
The premium that you might pay could be, $6 per share, with an exercise price of $100/share.
So, this would mean that you wouldn’t need to sell your Apple stock and you could protect your current profits incase the stock went down.
This means that you as the investor have approximately 6 months for the stock to make a move without having to worry about the stock falling through the floor while you own the shares.
This is because your put option gives you the right but not the obligation to sell the stock at $100 per share.
But..
As well as the share price the option contract value can move up , down or sideways.
If the stock moves up and goes to $120, the intrinsic value of the options contract is now $0 and the extrinsic value might be $1.30 as a result of time erosion.
What you bought for $67 can now be sold for $1.30 BUT the stock can now be sold for an additional $20 worth of profit.
Hmmmm…..
So in this case, you the investor, who bought the the option as insurance.
If the stock stays at $100 per share, the intrinsic value would again be $0 but the extrinsic value might be $4 due to time erosion of the option contract.
Now..
If the stock goes down to $60 a share, the intrinsic value of your option could be $40 and the intrinsic value could be $1, so what originally cost you $6 per 100 share is now worth $41.
Wow – we’ve covered a lot today.
Some of you will have understood this as you’ve been reading it. Some we’ll need to revisit this again.
If you want more information on how to use options to maximise your profitability when trading, please sign up to the Sofa Salary VIP newsletter below to get more tips on business building, and investing.
See you on the other side.
