By Market Authority
Are you making as much money as you can from your investments?
If you invest purely in stocks, the short answer is “no.”
If you’re not trading options, you’re missing out on one of the fastest-growing, most lucrative investment vehicles.
The options market has exploded in popularity over the last decade’ along with investing in general.
Despite that, though, the naysayers and skeptics remain out in force, proclaiming that options are too complex, confusing, and risky.
Talk about misconceptions…
If options confuse you, or you’re reluctant to give them a shot, let me say that options are not at all difficult to master.
In this guide, we’ll break down the basic fundamentals of the options market for you, shaking off stigmas, destroying myths and stereotypes, and showing you exactly how to profit.
Options are only risky if you don’t have the understanding.
Once you have that understand, you can decrease your risk and overall cost. They can be ultra-lucrative and are an excellent way to complement your portfolio.
Let’s first dispel the myths.
1. Options are only for the professionals with years of experience.
Not true. If this were true, you couldn’t find the thousands of sites and software solutions offered for beginners. This just isn’t true. In fact, if it were true, Options Trading Coach wouldn’t exist.
2. You have to be rich to trade options.
Again, not true. You don’t have to be rich. In fact, it’s oftentimes recommended that options traders start out with small accounts. I very rarely see new investors starting with gobs of money. They typically start off small and grow the monies risked after they’ve built up confidence.
3. Options trading isn’t so popular
Really? That’s like saying cable TV was a fad. Or that the Internet was a fad. Right now, as much as 5% of all accounts are approved for options trading… and that’s only growing.
4. 80% to 90% of all options expire worthless.
Wrong. Only about 30% of all options, as explained by the CBOE, expire worthless. The idea that 85% of options expire worthless is from a famously flawed SEC study… which didn’t account for exiting options prior to their actual expiration.
5. Options trading is far more riskier than stock trading
Again, not true’ Options allow you to invest with much less money for greater returns than stocks. Nice try with that one, though.
6. It’s too difficult to understand options strategies
If you know the difference between a put and a call, it’s not too difficult to understand the strategies. Once you understand the basics, you can understand even more.
People think it takes years to learn options… that this trading is complicated and tough to learn. But it’s not true. In fact, I’ve had people understanding options in a matter of days… if not hours. Once understood, options are as easy as trading stocks.
Options are just another way to invest in stocks.
They give you more flexibility, though.
Simply put, a stock option is a contract that gives an investor the right (but not the obligation) to buy or sell shares of an underlying stock at a set price on or before a set date.
You can buy and sell options contracts on regular stocks, indexes, ETFs and futures contracts. For example, if you wanted to trade options on Microsoft (MSFT), the MSFT stock would be considered the “underlying stock.”
When talking about stocks, each options contract is comprised of 100 regular shares of an underlying stock. If you bought one contract of MSFT, you would be trading 100 shares of the underlying stock.
Four Simple Terms of the Options Trade
No matter whether you’re buying or selling an option, there are two key elements to know:
Strike Price: This is the set price at which your option is exercised. – i.e. the target price of the underlying stock. For example, if MSFT traded at $30, you could trade an option with a “strike price” of 30.
Expiration Date: This is the month and year that your option would expire. If you bought a MSFT October 2013 call option for example, your expiration date would be the third Friday of October 2013.
The strike price and expiration date are fixed from the beginning of each options trade. These do not change.
You must also consider if you want to trade the long side or the short side of a stock.
If you believe the stock will trade higher, you can trade a call option.
If you believe the stock will trade lower, you can trade a put option.
You can find a full list of a company’s available call and put options and the various strike prices and expiration dates on the options chain. This can be found on Yahoo Finance, for example.
In, Out, or At the Money
Call and put options come in three forms:
In the money (ITM)
Out of the money (OTM)
At the money (ATM)
Simply put, for call options…
In the money refers to a strike price that is lower than the current price of the underlying stock.
Out of the money refers to a strike price that is higher than the current price of the underlying stock.
At the money refers to a strike price that is the same as the current price of the underlying stock.
These terms are essential.
Buying call options: Using the power of leverage
Let’s say Microsoft is trading around $30 a share, and you think it’s headed to $35.
You want to buy 100 shares, but it would cost you $3,000.
Maybe you don’t want to spend $3,000.
Here’s the alternative:
Rather than pass on the MSFT trade, you can buy one contract on MSFT in anticipation of its value rising in the future.
Buying that one contract, gives you the right to buy those 100 shares at a desired strike price at or before options expiration at a much lower cost.
How to Buy
To execute an option buy, you would “buy to open.”
Having looked at MSFT’s options chain, you want to buy the $32 call, which expires in six months.
To ensure that you get the best execution price, you’d use a limit order when you buy to open the trade.
Say that MSFT 32 call traded at $1.25.
You would take that $1.25 and multiply it by 100 to find your cost of one option.
Instead of paying $3,000 for 100 shares of MSFT stock at $30 a share, you could own 100 shares at just $125 a contract.
As you can see, that’s significantly less than $3,000.
You stand to make an even bigger profit if the stock moves to your $32 strike price.
If your $1.25 option runs to $2, as the underlying stock moves to $32, you stand to make 60%. If you buy $3,000 worth of MSFT, and the stock runs to $32, you make 7%.
Would you prefer 60% or 7%?
Buying put options: A better way to trade downside
The conventional method of trading stock downside is to short a stock.
This is risky, though because you’re borrowing shares and hoping the price falls.
If the price rises, though, you lose money and are often forced to cover your position by buying back at a higher price.
There’s an easier, less stressful way to do the same thing – with put options.
For example, if you think MSFT is ready to fall, you could buy an in the money MSFT 30 put option. This time – to make money – you’d want the stock to fall.
LEAPS options: Long-term Security and Control
LEAPS are long-term equity anticipation securities…
While it may sound a bit long winded, LEAPS are options with longer lifespans – between one to three years.
And it’s a very effective, lower-cost, higher return strategy for a long-term position.
You don’t have to be right about an underlying stock’s near term move.
You just need to be right over a period of one to three years.
Right off the bat, LEAPS are also much cheaper. In fact, if you trade a LEAPS option with an at the money strike price, your overall cost can be just 10% to 15% of the underlying stock price.
How’s that for lower risk and greater leverage?
The gains can be wild, too.
For example, let’s say a stock is trading at $60 and a two-year LEAPS contract trades at just $5 a contract.
If you were to buy five call options, your cost is $2,500 ($5 x 100 x 5) or (strike price x # of stocks in a contract x # of contracts). In the meantime, a regular stock investor would shell out $30,000 to own those same 500 shares
If the stock then rises from $60 to $75, you can exercise your option and take control of 500 shares at $60 a piece. Or, you can walk away with a sizeable gain of at least 200%.
Here’s the math
$5 (option cost) x 100 (number of shares in one contract) x $15 gain = $7,500.
That’s a percentage gain of 200% per contract.
Buying 500 shares at $60 (for $30,000) and cashing out at $75 would give you 25%.
The point is LEAPS can catapult a stock significantly higher than buying stock.
If you own a $50 stock and it runs by $5, you have a 10% gain. Not bad. But if you owned LEAPS for $1 a contract that same $5 move gives you a 400% gain.
When to use LEAPS
To diversify your portfolio for significant gains
When your outlook is one to three years ahead
To lower your cost…
To hedge against near-term company and market risks.
Not Sure which way the market is headed?
Straddle both sides of the fence
You can always count on the stock market for two things – volatility and unpredictability.
But while many investors sit back and wait for uncertainty to play out before making a move, you can still profit – even if you have no idea which direction the market or stock is heading next.
The flexibility of these two very closely related strategies means that you don’t have to be correct in order to walk away a winner. You can simply play both sides of a stock / index and then wait to see which way it goes before riding the profitable side.
Try doing that with a regular stock buy.
You can do this with a “straddle,” which allows you to straddle both sides of a trade.
Or you can “strangle” a position.
When to use an options straddle
The best time to use a straddle is when you think an index or stock is set for a big move in one direction.
Rather than buying or shorting the stock or index and hoping you’re right, you can plan for either scenario by hedging your bets in a much simpler, safer way. You can straddle.
A Biotech Straddle Example
Let’s say you’re looking at a biotech stock up for FDA approval next month.
The FDA decision is very likely to have a substantial impact on the stock going forward.
You’re just not sure how things will pan out so close to an FDA date. So you straddle.
With the stock trading under $40 – for example – your best bet is to trade an in the money strike price. With a straddle, you’d buy a call and a put at a 40-strike price in the same month. For example, you could buy a November 2013 40 put and a November 2013 40 call.
That’s a straddle.
Let’s say the price of a call option is $3.50 a contract, while the put side costs $4.75.
That’s a combined cost of $8.25.
You then multiply $8.25 x 200 for a total price of $1,750. That’s the price of your straddle.
With the straddle now in place, you’re positioned for whatever the FDA decides to do.
When the news finally breaks, here are your scenarios:
Drug Approval – The stock soars… taking the call higher, and punishing the put.
Drug Denied – The stock plummets… taking the put to the moon, and send the call option much lower.
How to Profit
Once the news is known, the goal is to exit the option that gets hit, while letting the profitable side run. You’ll profit from the overall trade set up if the combined total of your call and put exceeds $8.25.
Finally, here are some important options terms that you’ll come across.
Time Decay: The Force that Erodes Value
Time decay is an essential term.
It plays a big role in determining when and where to exit a trade.
As an option moves closer and closer to its expiration date, the chances of you turning a profit diminish. Time decay can erode the value of an option.
For example, you wouldn’t want to buy a lot of options with less than 30 days to expiration, unless you’re confident that the underlying stock will be in the money by that time.
When talking about time decay, it’s represented by a Greek term, known as Theta.
Theta refers to how fast an option will lose value as it approaches expiration.
Delta: It’s not just an airline
Delta is another Greek term, which refers to the value of an option, relative to the movement and value of the underlying asset.
Simply put, delta is the amount by which the option’s price will change for every $1 change in a stock. Every option carries its own delta valuation. Call options have positive deltas. Put options have negative delta.
For example, a delta of 0.80 means that for every $1 gain in an underlying stock, a call option would increase by 80 cents per share. Remember, because there are 100 shares in an options contract, a delta of 0.80 means that for every $1 the underlying stock rises, you make $80 per contract.
Prepare to Profit
Don’t let options scare you.
It’s very easy with repetition and practice.
There’s very little reason to get nervous with options. It’s simply a case of coming to grips with the basics and knowing what you’re doing.
Options should be an essential part of any investor’s toolkit as they help diversify, lower cost, lower risk, and offer attractive upside.
Naturally, there are risks.
But when you have a firm grip of the fundamentals, you can greatly mitigate those risks.
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