Before I start the article, I just wanted to state some word of caution
Option trading may not be suitable for everyone. You can potentially loose all your money with option trading. The weekly or monthly reward from option trading is widely discussed everywhere over the internet. What they fail to mention though is that, it has equal amount of risk.
As every stock market investing, option trading also comes with risk. You could potentially lose all your investment, if you fail to choose the right investment strategy.
I’m coming on this from a personal experience, where I’ve lost hundreds and thousands of dollars investing in stocks and options. I was a novice investor back then and didn’t know much. Therefore, I would suggest everyone to get your feet wet before diving deeper into the stock market investing world. Slow and steady always win race.
Table of Contents
Option trading 101
1. What are options? A beginner’s guide
Options are contracts (and they’ve expiry date) which gives option buyer the right to buy or sell the underlying stock or asset at a set price called strike price. The buyer is not, however, obligated to buy or sell the stocks. The right to buy or sell simply means, the stocks can be called away any time on or before expiry date.
Few of terminologies worth noting are – purchase of option, option premium, strike price, and expiry date.
The purchase of one option contract means 100 shares of underlying stock.
Option premium is the amount you’ll pay (for buying) or the amount you’d get (for selling option) while executing the option contract.
Yes, you can sell option contract even if you don’t have option to begin with. It is called sell to open.
Strike price is the price of a stock or assets that you’re willing to buy or sell at a future date while executing an option. The strike price can be above the current price of the stock. This is called out of the money (OTM). The strike price can also be below the current price. This is called in the money (ITM).
Expiry date is simply the date when the option expires. This is the date before which you’ll have to execute the option contract to close the position or simply it expires depending on the strategy.
To better understand the option trading concept, let me compare it with rent-to-own home contract. Some people like to think it as an insurance. But I’ll go with rent-to-own home analogy. The rent-to-own home contract gives buyer the right to buy the house. However, they are not obligated to do so.
When you invest in rent-to-own homes, you pay a non-refundable option fee (premium) for an agreement (contract) to buy the house at set date in future (expiry date). In most cases the house price is predetermined (strike price) during the contract.
The only different between these two are you cannot begin selling rent-to own home contract unlike option trading.
Types of Options
There are two options, named- CALL options and PUT options.
With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price.
With every “BUY or SELL to open” position on option trading, you must “SELL or BUY to close” as well unless you’re expecting the option to expire worthless or you’ll willing to buy the stocks, should they be assigned to you!
2. Trading an option
As mentioned earlier, you can either buy or sell options to open. This gives a total of four basic combinations of executing an option contract. You can either buy CALL/ PUT options or sell CALL/ PUT options. One you open your position on option trading, you must also close your position except in the situation discussed above.
The following table shows a broad picture of how basic option trades are executed. These are the most basic option trading strategies that you must learn before executing a completion combination of one or more. And to be completely honest, you don’t need complex combination. The only two option trades you need are the last two strategies: SELL a CALL and SELL a put. I’ll go in detail lower in the post why these two are the only strategies you’ll ever need for a profitable option trading.
| Open position | Option | Description | Transaction | Strategy | Close position |
|---|---|---|---|---|---|
| BUY | CALL | Gives you right to buy stocks | You pay the premium | Bullish | SELL |
| BUY | PUT | Give you right to sell stocks | You pay the premium | Bearish | SELL |
| SELL | CALL | Gives option buyer right to sell stocks | You'll receive a premium | Bearing | BUY |
| SELL | PUT | Gives option buyer right to buy stocks | You'll receive the premium | Bullish | BUY |
Common mistakes of option trading
Like every investment, stock or option trading comes with their own risk. One must be aware about these risk before investing money. Any activity that involves growing money involves risk, no matter what. Not taking any risk is a bigger risk because the money in bank does not grow. Inflation will eat away fraction of your savings. Therefore, everyone must invest to compensate the inflation, at the very least. While trading option, you must avoid the following common trading mistakes.
1. No exit plans
This may be the biggest common option trading mistake. You’ve got to have an exit plan. Once you open a position, you must also know when to exit out of the position. Every open position must be closed. Without an exit plan, you’re doing nothing but playing the game of luck, called gambling.
And you know who wins in gambling – No you!
By exit plan, I did not mean only for the losing position. Everyone should also have exit plan for the wining position as well. It does not take a minute to flip a wining position to losing in option trading.
A good rule of thumb is – to close out of the position, if you’re losing 100% of your position. If the position is costing you twice of what you’ve paid for, then you’ve got to exit that position. There is only a slim chance that the market will go in your favor again (not that it will never happen).
I would also like to exit out of the option, if it has gained more than half of the initial premium. When you sell an option, you get a credit. If you’ve already received more than half of the credit, I’d recommend to close out of the position to prevent any future reversal and capitalized the gain.
2. Ignoring the probability
When you’re trading an option, probabilities are your best friend. If you look at any stock option list (for different expiry dates and strike prices), probability of success is listed. Making a trade without looking at probability of success is a big mistake. Even though these probabilities do not mean you’ll win 100%, they are indicator of how profitable a trade can be.
Of course, nobody can predict the market.
3. Emotional attachment
It is not easy to detach yourself when your money is involved. Everyone opens a position with a hope to make a profit. But you’ve to understand, not every trade will go in your favor. It is easier to get emotionally attached, but the more emotional you are, the less strategic your plans will be.
There will be couple of small losses followed by (hopefully) bigger wins.
Another place where people are emotionally attached are, the stocks they choose to buy options to begin with. They love the stock so much that they keep on betting on it even the odds are against them. Like the great saying in the stock market goes,
“Don’t get married to your stocks”
Be willing to get out of the position, if it does not work out for you. People often choose to double down on the stock option, if they’ve lost money on the first trade. Most of the time, this will not work.
A good strategy is all you need to win in option trading.
Thing to consider while trading option
With the basic out of the way, let me share you a word of advice, if I may, about option trading.
Never BUY an option to open a position.
This is the worst way of investing on options.
The best way to trade an option is to SELL an option to open. Buying an option requires you to pay a premium. While selling an option gives you a credit. You should always trade option for a premium. This is the only way how I trade options.
Let me explain why I love selling options to open rather than buying.
Premium credit
The first and the foremost is of course, selling an option gives you a credit. You’ll get to set the premium that you want to shoot for. It is already predefined based on the strike price and your risk tolerance.
Unlike selling, buying an option requires you to pay the premium. After the premium is paid, you wait for the option to go up so that you can sell it for higher price. The difference is what you make the profit.
Time decay
When you buy option, time works against you. As your option moves closure to expiration day, the value of an option decreases. This is called time decay. The option which is higher in value reduces it worth as it gets closure to it expiration date. This is because it does not have enough time left and therefore, less people would want to pay for it.
On the contrary, when you sell option, you’d want it to reduce it’s worth so that you can buy it back and close your position. Time works in your favor by decaying the option cost. At expiration date, the option expires worthless and the seller keeps the full premium.
Unlike selling, buying an option requires you to pay the premium. After the premium is paid, you wait for the option to go up so that you can sell it for higher price. The difference is what you make the profit.
Stock movement
You buy an option with a strategy that the stock will either go up in value (in case of BUY a CALL) or it will go down in value (in case of BUY a PUT). You will only make money if the stock move away from your strike price. As the stock moves closes to the strike price, the option buyer starts losing money.
You, as an option seller, has extra advantage against option buyer. When you sell an option, you do not necessarily have to wait for the stock price to move away from the strike price. As long as the stock price does not reach strike price, you’ll make a profit. If the stock stays when it is, you’ll still make profit.
On the contrary, when you sell option, you’d want it to reduce it’s worth so that you can buy it back and close your position. Time works in your favor by decaying the option cost. At expiration date, the option expires worthless and the seller keeps the full premium.
Unlike selling, buying an option requires you to pay the premium. After the premium is paid, you wait for the option to go up so that you can sell it for higher price. The difference is what you make the profit.
Finally the two Strategies
The two strategies that I have been advocating are SELL a PUT and SELL a CALL. These are the only two option trading strategies I use most of the time.
1. SELL a PUT
SELL a PUT is an option trading strategy, where you are assuming the stock will move higher than the strike price. You are being bullish (in a way) in your position. Let’s explain this with an example.
Bank of America (Symbol: BAC) has been trading for $44.35. If I want to SELL a PUT of BAC for a strike price of $42.50 with an October 22nd expiry date, I’ll receive a credit of $ 0.53. This means I will receive $53 (since 1 option contract is 100 stocks) immediately in my account for executing one contract.
I’ll be betting on BAC that the stock will either remain or move higher than the current price. The other way to look at this is – I’m saying, the stock will in no way move below my strike price ($42.50); if it does that then I will start losing money. As long as BAC stays above $42.50 till expiry date (October 22), I will get the $53 credit. I can also choose to close out of this contract, for a quick profit before the expiration date.
The advantage of executing this option contract is that you’ll make money if the stock moves up or stays the same. On the contrary, if you had bought PUT, you are being bearish on your position. You will only make money if the stock moves down. If the stock stays at the same price, it will expire worthless.
I use this strategy with the stocks I would like to buy. I execute cash secured PUT which means, I’ll buy the stocks if they’re assigned to me. Let me explain:
I will execute SELL a PUT on the stocks that I’m looking to buy 100 shares. Let’s take BAC example again. I can execute the same option as above and wait for the option to expire. If the stock moves higher or stays the same, the option will expire worthless anyways, therefore, I don’t have to do anything. I will keep $53. If the stocks dips and ends below $42.50, 100 shares of stock will be assigned to me. I will pay $42.50 per share and still keep the $53 premium. Therefore, my actual cost per stock will be $41.97 ($42.50-$0.53). This is a great way of buying stocks. Had I bought the stock, I would have paid the full price of $44.35 per shares. By using this strategy, I’m getting stock at a discounted rate.
1. SELL a CALL
This is the next strategy that everyone should use while trading option. Since we are selling option, we’ll again receive credit. With SELL a CALL, we are being bearish and betting that the stock will not exceed the strike price. Let’s explain this with an example.
Let’s go back to Bank of America (BAC) again. For October 22 expiration date and the SELL a CALL strike price of $46, the credit received will be $0.45 (which is $45 per option contract). It has a good 79% probability of profit. Therefore, as long as the stock does not move past $46 strike price, we’ll make a profit of $45 at expiry date. We also can choose to close the position, should we make a profit before expiry date.
I would like to go a step forward with this strategy. I always SELL a CALL on the stocks that I already own 100 shares. This is called covered call. Let’s say, if I have 100 shares of BAC, I will place a SELL a CALL option for the strike price higher than my cost basis. I would trade this option to bring in extra cash. These extra premiums collected using covered calls are just like monthly or quarterly dividend, if the stock does not already payout dividend. I can continue selling calls until the stock is called away and my 100 shares are gone. If the stock moves higher than the strike price, I’ll have to sell 100 shares of my stock at the strike price. I’ll also receive the premium. Therefore, the total money received is total cost of stock by selling it at strike price plus option premium.
The SELL a PUT can be followed by SELL a CALL and visa versa. Once my 100 shares of stock are called away, I can start using SELL a PUT strategy to buy the stock at discount as mentioned before. When I’m assigned the stock, I can proceed with Selling a call. We can continue doing this cycle to bring in intermediate profits.
Conclusion
SELL a PUT and SELL a CALL are two very powerful option strategies to bring extra income. These are not completely passive but once you place your trade with a good probability of profit, you just let the market take its course. Starting with SELL a PUT, if the stock is not assigned to you at the expiry date, you collect the premium. If the stock is assigned to you, you can start placing covered calls and continue collecting premium with this strategy. Once the stock is called away, we are back to square one trading SELL a PUT. These two are one of the best strategies in option trading. These are not complex strategies and do not require special skills. Once you know the basic, you can start making trades. Start using these option strategies in you option trading journey and as always feel free to reach out to me if you have any questions.
