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Options are only risky if you make them risky!



April 12, 2009 – Comments (1)

This is a follow-up on my last post on options in March. i'm not a huge blogger, but since it seems that options are a popular Blog post at this time, so I'd like to chime in.

First of all I'd like to say that a mistake in options can be a big mistake, so if you are serious about giving it a try, I would recommend buying a good book about it and paper trading for quite a while before you do it. Most option strategies have names, such as calendar spreads, iron butterflies, etc... Don't try to master them all at once. Make sure your consistently making money paper trading one before attempting another.

Ok now on to options. An option is simply a contract to give someone the right to buy or sell a stock (or many other things) within a specific amount of time, at a specific price. That right to buy or sell has a specific value.  The value is determined by a few different things.

1) Strike Price- If the price to buy or sell a stock is already advantageous to the buyer of the option, it will be worth more to them than if the current price is not advantageous... An example If I'm offering to sell you an ounce of gold for $800 and it currently selling at $900, you would be willing to pay more of a premium than if I were giving you a chance to buy it at $1000. Why would you ever want the option to buy it at a higher price? That brings me to point #2.

2) Time- If you think gold is going to rise to well over $1200 by the time the option I gave you expires, then it would be foolish not to take me up on my offer. The more time I give you the more the option is worth to you. Especially if you notice point #3.

3) Volatility- If you look at a current chart on gold for the last month and it has been trading all over the place, there is a good chance that it will trading at a spot to make your option a good buy before it expires. That option would be worth more to you than if you look at a chart on gold and it's been trading at $900 for the last 6 months. Your option isn't worth much if there is no movement in the stock.

OK there is a little more to it than that, but those 3 things are probably the most important to consider when buying or selling an option. Now what if I told you that you can control all 3 of those things? Do you think that your chances of success might be a little higher? Well I'll get to how to do that in just a second, but first I have to talk about stocks a little.

If you can't pick a good stock, you have no business trading options! That's right I said it. The underlying stock itself is the most important part of the option. If you don't know how the stock will behave, you don't know how the option will behave. But let's assume that all you foolish blog readers do know how to evaluate stocks. Congratulations, you already know how to control an options volatility! You guys that like the small cap growth stocks know that they are volatile and those of you that like J&J and Proctor and Gamble know that those stocks usually aren't. So you already have 1/3rd of this down.

Now let's explore the normal way of trading stocks. You start by researching a stock that you want to trade. If you don't think that it will go up or down, you research another one. Normally if you think a stock is going down you short it. (Yeah I know most of you don't do that because of the risk involved but some traders do so we'll go with that.) When you find one you like to go up, you place an order to buy it. If you want to buy it at a lower price you set that price with your broker and deposit enough money into your account and wait for it to get down to that price. Once you own a stock the onlyway to hedge your risk is buy selling some of the shares.

Now here is the way I trade with options. I start by researching stocks.

If I see a stock that I don't think will go up or down for a while, I might still trade the options. I'm not going to go into detail too much here, but I might do a straddle, or a calendar spread, the point is that I can make money if the stock doesn't do anything and I can do so in a way to know exactly what my maximum risk is before I trade. Those trades are more advanced so I'll save the details on those for another blog post. I will say that I don't do these trades a lot, because other trades take less time and effort, but these things are a god-send in a flat market.

Now when I come across a stock that I think is going down, I never short it. I simply buy a put. A put is the right to sell a stock at a given price within a given amount of time. I have a few choices I can buy put that is out of the money, at the money, or in the money. (We are back to point #1 here.) If I think that a stock is going to drop like a rock, I might take one out of the money. This is more like buying a lottery ticket though. I will probably pay like a dime for this type of option and have a small chance for a much bigger payday for very little risk. I usually buy puts at or near the strike price. (I usually try to get the closest one just under the strike price). I hardly ever buy a put really far into the money. (Although I have before.) The reason for that is that those options sell for more and any option that is in the money is going to pay me about the same amount of money if I'm right, if we are dealing with the same timeframe. When I am buying options, I usually pick small time-frames because I have to pay more for more time. That is more money lost if I'm wrong. Buying a put is just like shorting a stock in that I never have to own the stock. I don't even have to borrow it! If I'm right, I just sell my put for more money than I paid for it to someone else.

Now for my favorite way to trade options! Let's say I find a stock that I'm sure is going up. I sell a put. Not only do I sell a put, but I sell one with the longest time-frame possible! I look for an type of option called a LEAP. LEAP's have time-frames that can go on for up to 3 years. Why do I do this? Because the other guy is paying me for my time now! This is a stock that I want anyway. If I didn't want the stock, I might pick a shorter time-frame and just sell puts one after another as they expire. Now my broker will let me trade on margin, so I don't even have to have the total purchase price to buy the stock in my account if the other guy exercises his option, but I personally do that anyway. The reason why I do that is that I've seen other guys lose money having to sell a stock when they didn't want to, to cover an exercised option. The way I look at it is the guy that bought the option has already given me some of the money to pay for the stock, I can put up the rest for a while and I can always change my mind and buy a put if I want to spend the money somewhere else. Now I do the same thing that you do, I pick a price that I want to pay for a stock, but if the stock is already selling for the price I'm willing to pay or lower, I will always pick a strike price that is even lower than that for my put. Why? Because I think that this stock is going up and if I'm right, the guy that I sold it to will never exercise his option giving me free money! I then sell another put with another chance at free money. Wait, you say, you've got to wait 3 years for that option to expire! Nope, I just buy another put for a cheaper price to close the trade andthen I can sell another put. The guy that I sold the put to has 2 things going against him. First as the stock goes higher, his put is worth less, and second as time goes by, his put is worth less. Let's say that the stock drops to my strike price and he exercises his option. I just bought the stock that I wanted for the price that I wanted and he paid me to do so. I need to put some numbers here to explain. 

JPM is currently trading @ 32.75. I want to buy it at 30, so I sell January 2011 put with a strike price of $30 and receive a premium of $10.25 cents. If the price falls to 30 and the option gets exercised. I've really only paid $19.75. ($30 - $10.25 I recieved in premium) If the stock goes up enough, I could buy the same option for say $5 and close out my position and walk away with $5.25 of free money or sell a new option adjusted for the new price for another $10.25. (Assuming that I still think JPM is going up)

Now lets just say that the option was just exercised and I own JPM and its currently trading at say $27.75, but I've only paid $19.75 for it. The first thing I want to do is pick a price that I want to sell it for. I think that I want to sell it for $35, so this time I sell a January 2011 call (the right to buy the stock) immediately for a strike price of $35. I receive a premium of $9.15. Now my true cost basis for the stock is $10.60. ($19.75 - $9.15) If the option gets exercised, I receive $35 for a stock that I paid $10.60 for or a 330% profit. (Not adjusted annually) If it's not exercised, I can sell a another price adjusted call for another $9.15 making my cost basis only $1.45, ($10.60- $9.15) or a 2414% profit! If I manage this a 3rd time, I can't calculate a profit because the stock was free. Here's the funny thing with the call though, Once I'm at this point it's pretty hard to lose money. If the stock drops, I can buy the call for cheaper than I sold it for and sell another call. If the stock doesn't move I can still buy a cheaper call as time goes by. If the stock goes up and gets exercised I obviously profit. My cost basis is always going to be lower than the stock price, so unless there is a sudden bankruptcy, I can sell covered calls all the way down until the stock price hits zero and still be ahead of the game.


How did I accomplish all of this? By knowing how volatile the stock was, by using time to my advantage on the options that I sold, and by picking strike prices that I wanted to buy and sell a stock at anyway. I do this trade many different ways. A lot of times I just keep selling puts that never get exercised. Sometimes the put gets exercised and I sell a ton of calls that never get exercised. I almost always use a LEAP for the put, but a lot of the time I'll use shorter term calls. The important thing is I know why I'm doing it different. They call them options for a reason! You have a ton of choices to pick from and you should always try to pick the choice that gives you a strategic advantage. If you sell a  put or a call that is too deep in the money it will get exercised! If you sell a put or call that has a short term, it has less of a chance to be exercised but you make less money per sale. (although you ususally can sell a lot more that don't get called.)

The last thing I want to mention here is that you still have to keep up with your homework on the stock. You don't want to keep selling puts on a stock that suddenly now has a negative outlook. You also want to be sure that new news on stock isn't overlooked to the point that pricing your calls too low.

How do you make options risky? Simple. Sell naked calls. Sell naked puts on stocks you don't know. Buy out of the money calls or puts. Try to do iron butterflies, diagonal ratio spreads or any other options strategy without understanding what your doing completely.

I hope this helps and happy trading.

1 Comments – Post Your Own

#1) On April 12, 2009 at 3:35 PM, arboretum (28.05) wrote:

Any of the options strategies, with the possible exception of covered calls, are more risky than long-term buy-and-hold investing in a normal market. The fact that the market hasn't been normal lately doesn't make options any less risky, although it certainly adds risk to buy and hold.

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