An option is a contract that enables an investor to buy (known as a call option) or sell (referred to as a put option) an underlying asset at a fixed price over a specific period of time. Classified as a derivative, most investors use options to supplement income or to hedge against market downtown. In this article, financial professionals provide 6 insightful and useful tips for options trading in 2020.
When Call Options Are Used For Income Generation, The Strategy Is Named A Covered Call Strategy
“A call option is an agreement that gives an investor the right, but not the obligation to buy a stock (or bond or commodity) at a specified price within a specified time period. Specifically, a call option contract gives the holder the right to buy 100 shares of the underlying stock at a specific price, known as the strike price, up until a specified date, known as the expiration date.
Call option contract holders can hold the contract until the expiration date, at which point they can take “delivery” of the 100 shares of the stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.
An option contract will expire worthless if the stock price is less than the strike at the expiration date. Call options can be used for income generation, speculation or tax management.
When calls are used for income generation, the strategy is named a covered call strategy. This involves owning the stock at the same time as selling a call option, giving someone else the right to buy your stock. The investor collects an option premium and hopes the option expires worthless.
He pockets the premium and generates additional income. The risk is that the upside to the stock is limited during the time that the contract is in effect. If the strike price is $102 and the stock jumps to $105, the investor’s stock is called away and he only pockets the $2 gain ($102-$100) along with the option premium payment. When call options are used for speculation, the investor does not own the underlying stock. They only want to get the opportunity to own the stock if the stock goes up. In the example above with the stock at $100 and the strike price at $102, if the stock jumps to $105, the call option buyer pockets $3 ($105-$102) less the price of the call option.
Of course, if the stock only moves to $101.95 (or any price below the strike price), the call option buyer has lost 100% of the option cost.
A put option is the opposite of a call option; it gives an investor the right, but not the obligation to sell a stock, bond or commodity at a specified price within a specified time period. Specifically, a put option contract gives the holder the right to sell 100 shares of the underlying stock at a strike price, up until a specified date, known as the expiration date. The buyer of a put believes the stock will drop below the exercise price before the expiration date.
The exercise price is the price the stock must reach for the put option contract to hold value. Consider the investor who purchases one put option contract for 100 shares of the underlying stock at $1 per share, or $100 ($1*100). The strike price of the shares is $10, and the current stock price is $12.
This put option contract has given the investor the right, but not the obligation, to sell shares of stock at $10. If the stock drops to $5, the investor’s put option is in the money and they can close the option position by selling the contract. On the other hand, the investor can purchase 100 shares of ABC at the current market price of $5, and then exercise the contract to sell the shares for $10. Disregarding commissions, the total profit for this position is $500, or 100 shares multiplied by the difference between the strike price and the market price ($10-$5). Put options can also be used as a hedge. If the investor in the previous example already owns 100 shares of the stock, they could buy the put option to hedge against a decline in share price.
Many individual investors are enamored with options because of the high return potential.
For me, options are just additional leverage.
If you buy one share of a $100 stock you have to have a $100, but if you want to get access to the $100 stock and buy an option for it to go to $101 (for a $1/$100 or 1 percent gain if you owned the stock), you might only have to have 10c.
If the stock goes to $102, you’ve made $1 on your option cost of 10c or a 1000 percent gain.
So options can be all about leverage. Options also usually have a much higher commission cost than stock commissions, especially for institutional investors.
Furthermore, the spread between the bid and ask can be quite large (as much as 50 cents at times). That means that when you are trying to buy an option, you might have to pay $0.50 more than you would at the same time to sell the option. And if, in fact, you made $0.50 on the option, in reality when you tried to sell it, you would not make any money (the $0.50 gain would be offset by the higher $0.50 cost to sell the option).
Put options are also speculation if you don’t own the underlying stock. If you are just buying a put option, you are making a bet that the stock will go down. Just like you are making a bet that the stock will go up if you buy a call option.
The reason I use the word “bet” is mainly because of the time frame involved. Most institutional investors who are fundamental investors, analysts and portfolio managers will tell you they have no idea how quickly the stock will go to their estimate of fair value.
Sometimes it may take a month and sometimes it may take two years. Most individual stock options expire within a short period like three or six or nine months—quarterly cycles. Now there are even weekly options! So, not only do you have to have a very good idea about the true value of the stock, but you also have to get the timing right as well. Finally, as I mentioned above, the commission costs are generally much higher than the cost to purchase an individual stock.
Even though the costs have come down dramatically in recent years, for some brokers, it can still be as much as 10x the cost to buy or sell an option as a stock. At SaLaurMor, we restricted our use of options to hedging and the overall use of options was quite rare.
I had a great lesson from our time at Citigroup regarding options. When I started at Citigroup in early 2008, I had very high conviction about one particular short idea. The main risk to any short idea is the possibility that the company is acquired, since it can cause the price to spike overnight. At the time, this security was trading in the low $60s and I thought the risk of an acquisition was low.
However, my manager recommended talking to the derivative specialist at Citi just to see if there was a low-cost way to hedge this risk. We had a great discussion. I became much more knowledgeable about options after my colleague explained to me that we could buy a call option close to $90 (the price I thought the company would get taken over for would likely be over $95. So we would earn at least $500 [($95-$90) x 100] for each contract. He also explained that we could pay for the cost of the call options by selling put options and taking in the premium).
My big mistake here was setting the price too high for the strike price of the put option. I figured that the security we were shorting was worth $40 in our “downside risk” scenario. So, our derivative specialist told us we could sell the same total dollar amount of puts at a $40 strike price to offset the cost of us buying those calls at $95. Great, no cost outlay and we are covered in almost all scenarios, right? Well, as many investors may remember, 2008 was not the best year for stocks.
Our great short idea dropped from around $60 to much lower than $40 and our short was hedged perfectly with the puts we had sold so that for every dollar the stock went below $40, we did not make any money and the call option expired worthless. I learned a valuable lesson about options, but also about fear. We obviously could have just left the short position on without hedging the upside and made a lot more money, but we were fearful about the company being acquired. We had conviction in our top idea, but we didn’t have absolute faith.”
Joel S. Salomon, CFA, FSA, Chief Prosperity Officer, SaLaurMor Prosperity Management
Not Borrowing A Trading Approach From The Stock Performance, Maximizing On Liquid Options, Always Have An Exit Plan
“I am a personal finance coach and an investment analyst and when it comes to trading options, I have to say that it is not enough to learn how to assess and identify the best options to work for. Crucial trading tips that I believe you should be implementing come 2020 include:
Not borrowing a trading approach from the stock performance: I must warn you that options are derivatives and their price won’t always be in tandem with that of the underlying stock. What works for the stocks will almost always not cut it. You will need a different approach free of the stock market influence.
Maximizing on liquid options: But how do you tell if an option is liquid enough? By ensuring that the contract has willing sellers and buyers at all times. You also get to check for liquidity by ensuring that the price of the next trade will be as close to the price of the last trade as possible. By trading illiquid options you increase the probability holding onto a losing trade longer.
Always have an exit plan: I believe what separates winners from losers in the options markets is knowing when to quit. And that no matter how profitable or promising a contract may seem, you must always have an exit plan.”
Edith Muthoni, Chief Editor, Learnbonds.com
If You Are Day Trading And Buying Calls And/Or Puts Because You Are Expecting A Price To Go In One Direction, Stay Away From Individual Stocks And Trade SPY Options
“As someone who trades options as more of a hobby to supplement my income, I have very strict rules. Above all, if you are day trading and buying calls and/or puts because you are expecting a price to go in one direction, stay away from individual stocks and trade $SPY options. If this is your trading strategy then your sweet spot is between the US market open and the EU close. However, if you are looking for a hedge and/or to cost average your position on the downside then selling covered calls and or hedging and buying puts is a great strategy. In fact, you can provide a great income if you own the underlining stock and you are expecting it to sit in a trading range as you can sell covered calls to bring in premium and either buy them back at a lower price or they can expire worthless. Another way to make money in options is if you are expecting a big move, (usually post news announcement, i.e. earnings), you are not sure which way the stock will go, but you know it will be a big move, then a straddle option is a good strategy. This is when you buy a call and a put at the same strike price and expecting a sharp move more than the overall premium paid. Overall, options are a lot of fun if you know what you are doing, however, rookies beware, it can be very painful and expensive if you do not.”
Danny Ray, Founder, PinnacleQuote Life Insurance Specialists
Options trading can seem like a formidable undertaking to the uninitiated. Yet, there are many advantages to the options market. The most important thing to remember for beginners, however, is to know when to stop. It’s highly advisable to do your due diligence, and take your time understanding the key points that constitute options trading. For those investors interested, have a look at our top 5 investment newsletters with reviews for the likes of Biotech Breakouts and Jason Bond Picks for more information on options trading. Take into account what these experts have discussed, and consult a financial professional before investing your hard-earned money.