Understanding and Utilizing Options (New Investor Friendly!)

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via ericwcharmon:

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((SMALL AUTHOR’S NOTE–Although the title says NEW INVESTOR FRIENDLY, I think it’s worth mentioning that I actually do not recommend options trading for individuals who are brand new to investing. Cut your teeth and learn as much as you can with traditional trading first, and after you feel comfortable with terminology, examining charts, collecting research, and spotting trends, then consider moving on to options. Just a small disclaimer on my part.)

A quick look through the online investing community and it becomes clear that this blood-red market day delivered some pretty hard hits. In fact, on the worst day for the stock market since June of 2016–where even Amazon dropped a solid 6%—it’s probably fair to say that many people’s weekly percentage goal was completely wrecked.

Of course, this isn’t the case for everyone. I personally saw a 34.45% increase for the day–regardless of the hard downward spiral of the market–and am currently sitting on a 156.48% gain for the week.

This isn’t due to finding some top secret penny stock and riding it to the moon but rather, relying on options trading in place of traditional stock trading.

Many new investors–and even long time traders who are just less familiar with the subject–shy away from options trading due to its complicated nature and high risk levels, but that hasn’t stopped those interested in learning from trying to figure it out.

I’m going to do my best to explain options trading in it’s most basic form–with the hopes that those who read this can then take that, and continue to educate themselves on the concepts and ideas but with a stronger understanding going in. For those of you who already have a firm grasp on the subject, feel free to add on or correct me should I make any mistakes, but please keep in mind that I will be tackling thing using mostly broad strokes as an ‘introductory course’ of sorts.

First and foremost…it’s worth covering some key terms that are important to know and that you’ll be seeing repeatedly…

TERMINOLOGY:

OPTION – An option is–in it’s most basic form–a contract that gives one person–the option holder (notice I had option, not specifically call or put)–the right, but not the obligation to preform a specified transaction with another party.

CONTRACT– For our purposes, a contract is a term that represents 100 shares of an individual stock. So, obviously this means that for every contract you buy, you’re actually–in essence–buying 100 individual shares of the company in question, and conversely–for every contract you sell, you’re selling 100 shares.

PREMIUM – A Premium is simply the price paid per contract.

CALLS – In it’s simplest form, we can define a call as an option to buy an asset (or assets) at an agreed price on–or before–a particular date.

PUTS– On the opposite end of the options spectrum, there are puts. These can be defined as an option to sell an asset (or assets) at an agreed price on–or before–a particular date.

STRIKE PRICE – The strike price in either option (calls or puts) is the agreed upon market price of a stock (determined at the point of the original transaction) at which the owner of the option can either buy (in the case of a call) or sell (in the case of a put).

IN THE MONEY (ITM) – An option that is in the money means slightly different things depending on if it is in regards to a call or a put. For a call option, ITM means that the option has met–or is higher than–its strike price. For a put option, ITM means the market value of the stock in question has met–or is lower than–the strike price (it’s also, in my opinion, the dumbest term in the world of investing).

OUT OF THE MONEY (OTM) – This, I feel, is pretty intuitive, but for clarity’s sake, we’ll go over it. If an option is not In The Money, it is–you guessed it—Out of The Money (I won’t use this term, but some people do. So it’s worth just having the term in your back pocket).

So, what is Options Trading, and how is it different than Traditional Trading?

The main thing to keep in mind when discussing the differences between options trading and traditional trading is the fact that, in my experience, you’re facing a much more extreme risk/reward ratio, especially if you’re primarily use to trading penny stocks. While building your portfolio through traditional trade is certainly possible, it can be a frustrating, slow, and time consuming process before you’re able to even consider using it as a secondary source of income, especially if, for whatever reason, you find yourself unable to execute day trades. Not to mention the hours of time–ideally daily–you spend on research for the next investment, which (assuming you’re working with pennystocks) may only actually result on $100 gain or so.

Counter to this, trading options can be a fast way to build up your portfolio and quickly transition your stocks from a hobby into a substantial percent of your weekly income (not to mention that seeing that you’re already at a $800 gain before lunch is pretty fucking gratifying).

The risk of course–as with all things–must be equal to or potentially greater than the rewards. Just like with traditional stock trading (again, particularly when trading penny stocks) your potential for profit increases with the amount of contracts you’re buying or selling…and given their cost (which can range from cheap-as-shit all the way to awh-hell-no) this, even at just the risk of losing your initial investment, can be devastating (and even more so should things go verywrong–particularly with selling calls–where the maximum loss potential is essentially unlimited).

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This is why it’s important to understand that—contrary to what you may see around the online investing community—that simply yolo-ing on an option trade without doing your research is a sure-fire way of losing your money. Proper research, pattern recognition, volume spotting, and any other Due Diligence tool you have in your tool box are just as important in options as they are in traditional trading–if not more so.

But, assuming you can master the basics–and hopefully continue learning even afterwards–you’ll soon find yourself making more profit than you ever thought realistically possible–even on days like today, where the market comes crashing down–the wondering how you ever thought an $80 gain was something to be excited over.

Getting Started With Options Trading

(I primarily use the Robinhood app for my day-to-day trading, so all of my graphics will reflect that.)

Assuming you’ve already done your due diligence and have decided on which company you’d like to invest into using options, you’re going to find yourself with a few different decisions to make. The most important of which being on whether you’re going to utilize a CALL or a PUT option.

Remember, when dealing with Calls we’re almost always (there are a few exceptions for more complicated plays) expecting the stock in question’s market value to INCREASEwhile with a Put we are anticipating the stock’s value to DECREASE.

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With that in mind, we want to plan accordingly. We probably wouldn’t consider a PUT option for Apple, just like we wouldn’t consider a CALL for Snapchat (I suppose you could but…fucking yikes). Take careful not of trend patterns and volume during your selection process, along with any news surrounding the stock you’re interested in to avoid running into unexpected surprises that will affect its market value.

Regardless of which direction you want to go with your option trade(s), your next decision after choosing which type of option will be in regards to the terms of the contracts you’re about to pay for.

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Seeing all this data, different numbers, and percentages may seem a bit overwhelming… and that’s alright. Most new investors that I introduce to options usual decide at this point that they would rather go back and watch some more tutorials or read a few articles before jumping in, and more often than not, that’s the right call. But, if you decide to keep moving forward (sometimes the experience of even just buying a single contract is a better way to learn than binge watching investment videos on youtube) than just keep in mind that there are three key pieces of data that you need to examine.

The first, is the date that you want you option to expire/be exercised. It’s pretty tempting to select the closest day available (or at least it was for me, but I’m also impatient) but keep in mind that your option’s proximity to its expiration date is one of the many factors used to determine its contract price. Also, selecting a farther away expiration gives your stock’s market value more time to reach (or get closer to) its strike price if it has a way to go or tends to fluctuate in value–and the closer it is to its strike price (depending on the type of option you’re using), the more you profit.

Be sure to really look into the the overall movement of your stock over the last week (or longer). Take special note of the stock’s support and resistance lines, along with its current and average volume so you can get a feel for how many buyers and/or sellers are paying attention to it. A stock with outrageously high volume will obviously be more volatile and have more dramatic changes in price, while a stock with low volume means you may run the risk of their not being a buyer or seller once your option ends (whether through a transaction or expiration).

It’s also worth nothing–mostly because it is an aspect often overlooked by new investors—that in reality, only around 20% of options are actually exercised. That means that the vast majority–80%–have their contracts sold and/or bought–presumably for a profit if the option is being closed early. What this means is that–or at least **the strategy that has allowed me to increase my portfolio value over 115% in the last two trading days—**is that your goal shouldn’t necessarily be to reach the last day of your contract. I regularly sell contracts that have a lifespan of over a week the very next day after purchase if I’m happy with the profit margin it’s reached. This is especially true if you think that there’s a chance that the market value of your stock could suddenly change and start moving in the opposite direction.

Because of this, I think it’s helpful to view the expiration date of your option as more of a deadline rather than the finish line. Your goal is to make as much profit as you can in the time between your day of purchase and the expiration date. If you hit a solid profit before that day, that great. Bring it to a close and enjoy the win.

What You Need to Know About Buying and Selling Calls

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By this point, you know that by utilizing a Call option, we’re essentially betting that the market price of our company is going to increase. And if that’s all that you know about Calls at this point, that’s okay. Let’s break it down further.

Buying a Call Option

When buying a Call option, you’ve hopefully picked a stock with a solid upward trend (or some sort of catalysis to send it’s market value to the moon) because the profitability lies in the stock reaching–or even better–surpassing the Option’s Strike Price. If the market value of the stock doesn’t increase beyond the Strike Price however, then it wont be profitable to exercise and the option will expire…(ugh) Out of The Money– and worthless, leaving the buyer with a loss of their initial investment.

The great thing about this scenario is, there’s really no limit on it’s profitability. Your profit will directly correlate with the amount the stock’s market value increases above the Strike Point.

I actually saw something the other day about a investor who purchased $4,000 worth of $IGC Call Options during their boom not long ago. His profit was something around 14k, if I remember correctly.

Selling a Call Option

I want to preface with this saying that I firmly believe that selling a Call option is the riskiest play in options trading and could very easily destroy your portfolio and become a giant dumpster for your money. This is espically true for the trading strategy known as Uncovered Calls, which the seller doesn’t own the amount of shares needed to complete the contract, and would be forced to purchase the amount of shares needed to complete the Option our of their own funds if exercised.

However–if done properly (by someone who truly understands what they’re doing and what moves to make) selling Calls can be very profitable.

When SELLING a Call Option, the seller (let’s say it’s you) agrees—and IS obligated to–sell the contract (or contracts) purchased at the agreed upon Strike Price, if–and only if–the option is exercised. In return for taking this risk, you (again, the seller) receives the premium that a buyer–or potential buyer–would pay to buy the option. The real goal–and where the profitability lies in selling Calls–is in the hope that the Option reaches its expiration date without increasing–or at least not enough to reach its Strike Price. In which case, the Option expires without being exercised and you keep the premium paid as pure profit.

But, as I said, this can also go very wrong, and should the stock’s market price reach its Strike Price and be excised (the buyer deciding to collect on the amount of shares represented by the amount of contracts purchased–this leaves the original you responsible for for delivering those shares–whether you’re currently in possession of them or not, which, should you have to buy them to fulfill the deal–could royally ruin your week.

What You Need To Know About Buying and Selling Puts

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As we’ve discussed, counter to Calls, we invest in Puts if we expect the market value of a stock to decrease. Of the two options, I personally believe that Puts are much easier to predict, and while they can still produce unbelievable returns, they generally will not be as profitable as Calls.

Buying A Put Option

When buying a Put option, you’re granted the right–but are not obligated to–sell your selected stock at it’s strike point, assuming it reaches–or moves below that strike point (below is good–remember, with a Put our goal is for it to bottom out). To do this, we, as the buyers, pay a premium (the cost of the contract(s)) to the seller, who–as we mentioned above–takes on a substantial amount of risk, being that they are obligated to buy the contract(s) from you (the Put buyer) at the Strike Price.

As I mentioned above, only around 20% of options are actually exercised. Most investors who have purchased a Put will sell the contracts off before the execution date and collect their profits, which, in my opinion is more advantageous than receiving 100 (or more, depending on the amount of contracts) shares of say….Snapchat.

Selling A Put Option

The concept of selling a Put Option may be the hardest to explain. Unlike with Selling a Call Option, where the seller is obligated to sell the contracts if exercised, an investor who is selling a Put is obligated to BUY the contract(s) at the determined Strike Price. This can be used to your benefit as the seller to purchase a contract (100 shares of the company in question) for a price that is lower than the current market price.

There’s a reason this is the most underused of the options. It’s hard to fully grasp and even harder to brutalize correctly, and while I’m sure someone out there could use it to their benefit, I personally recommend ANY OF THE OTHER OPTIONS before selling a Put.

Obviously this isn’t all there is to say–or learn–about option trading. I could probably write a similar article to this on on each aspect of Options and still be unable to fully cover everything, but hopefully, those of you that have stuck with me through this entire article found it helpful, and are able to walk away with a better grasp on the core concepts of Options Trading, and—if you still feel unsure about trying your hand at Options tomorrow, I hope this helped put you on the right track to a better understanding!

-Eric

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