Options Trading for Beginners: Part 1

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

A few years ago I wrote a series of articles for people who are completely new to the idea of trading options. Options are a really interesting and potentially profitable instrument when used properly, and are certainly my favorite. Since this letter has new readers all the time I felt the time was right to do another set. So, beginning this week we’ll cover the basics of options for the sake of new traders and would-be traders.

The reason many people are attracted to options is because of the leverage available. Options can potentially make a lot of money on a small investment. The people who use options like this are speculating.

A completely different set of investors uses options in a completely different way – for protection of their investment in stocks or other assets. These investors are not speculating; they are hedging.

And yet a third group uses options as part of a conservative strategy to generate cash flow – either a modest amount with very modest risk, or a potentially larger amount with somewhat greater risk.

These are the three modes in which options can be used – fast growth, protection or current income. Almost everyone has a use for at least one of these. If that includes you, read on.

There are just two types of options – Puts and Calls. With just these two components we can build positions of endless varieties. The various types of positions are called options strategies.

Every option is related to some underlying asset. This can be a stock, an exchange-traded fund or something else. For our first examples we’ll assume that the underlying asset is a stock – the stock of the biotech company Actavis plc (ACT).

Let’s say, for the sake of example only, that we are very bullish on ACT. We like its business prospects and we like the price action shown on its chart. We think (let’s say) that ACT will be at a much higher price three weeks from now. We think it could easily move from its current level at $298.36 up to its recent high around $317.80, a 6% increase. Here is its chart as of April 23, 2015:

If we bought ACT stock, for each hundred shares we could make $1980 if we’re right about this move. On the other hand, we will have to tie up $29,800 for each hundred shares (or half of that in a margin account).

An alternative would be to buy, not the ACT stock itself, but an option to buy that stock. If the stock then does go up in value we stand to make a profit. Options to buy stock are referred to as Call options. If we decide to exercise them, then we “call away” that stock at the specified price. We get the stock by paying the option seller the amount of money that was agreed on in the option deal.

For example, there are available options to buy ACT at $295 per share at any time in the next 56 days (through June 19, 2015). This $295 price is called the strike price for these call options. For each hundred-share lot the options cost $1380 ($13.80 per share). The price of an option is referred to as its premium. To buy these options we just make a few clicks in our brokerage software package and pay the $1380 premium. We then have the right to buy the ACT shares by paying an additional $295 per share, or $29,500 for the 100-share lot. If we exercise that right, we will then own 100 shares of ACT. Our cost per share will be the $13.80 we paid for the call option plus the $295 that we will pay in addition to exercise. That’s a total of $295.00 + $13.80 = $308.80 per share.

We are not obligated to exercise our call options. We can hold on to them and wait for ACT to hit our target. If it does, then we could exercise our option and flip the stock at that time. If we’re still waiting when the options expire in June, if ACT at that time is anywhere above the $295 strike price, it will be in our interest to exercise the options. Otherwise we won’t bother.

Let’s look at the potential profit and loss on this trade. If ACT goes up to $317.80 as we expect, we could exercise our option and own the stock at a total cost of $308.80 as calculated above. We could then sell it for $317.80, a gain of $317.80 – $308.80 = $9.00 per share ($900 for the lot). That 6% move in the stock will have netted us a profit of over 65% on our $1380 investment.

If ACT goes nowhere and is still at its present price of $298.36 when the option expires, we will still be able to salvage a part of our cost. We could exercise the options at that time, buying the stock for $295; sell it at $298.36, and make positive cash flow on that transaction of $3.36 per share. Subtracting that from the $13.80 per share option cost, our net loss would be $13.80 – $3.36 = $10.44 per share.

And finally, if ACT goes down and stays below $295, there will be no point in exercising the option at all. We will then have lost our $13.80 per share option cost.

So, our worst-case loss is $1380. This is a lot less than the many thousands we could lose if we bought the stock itself and it cratered.

We need the stock to go up in order to make any profit. If it stands still we’ll lose money.

But if the stock does go up we can score to the tune of more than 10 times the percentage gain in the stock itself (65% of $1380 vs 6% of $29,836).

This amplification of the potential profit on the trade is the leverage that the speculative option buyers use in hopes of making big profits.

Is this a good trade? Could it be made better?

We started when the stock was at about $298 per share. It looked as though it had a good chance to go back to its recent highs around $317.80. We evaluated buying options to purchase the stock as compared to buying the stock itself. We found that we could buy call options which gave us the right to buy the stock at $295 per share for 56 days, until June 19, 2015. Those options would cost $13.80 per share.

If the stock did go up to $318 we could exercise our options to buy the stock at $295. We could then sell it at the $317.80 market price and pocket the $22.80 difference (our $317.80 sale price less our $295 option strike price). Subtracting the $13.80 cost of the options from that $22.80 gain would leave a net profit of $9.00 per share. Since option contracts are sold in 100-share lots that would be $900 profit per call option contract on an investment of $1380 per contract.

The question we asked above – was this a good trade?

To answer that we have to understand the factors that will determine our profit or loss.

The first of these is our outlook for the stock itself. Buying call options only works out if in fact the stock goes up. This is different from buying the stock itself. When you buy a stock, if it remains at your purchase price you have no gain or loss. As long as it stands still, if you don’t mind leaving the capital tied up in that stock (which you should), you could theoretically hold on to that stock indefinitely and never make or lose any money. But options are different. They expire. We cannot buy them and hold them so we must be right now, not at some indefinite future date.

In this particular trade, if the stock remained flat at $298.36 until June 19 our option would lose most of its value. At that time it would be worth about $3.36 per share – the amount of discount to market value that its $295 strike price represented. Although options have some enchanting attributes they don’t confer magical powers. If we use them to make a bet that a stock will go up, we can’t win unless in fact it does go up.

Using options in place of stocks does not reduce our need to be right about the stock. So let’s look a little deeper at this stock’s chart.

In our trading classes we teach the art and science of evaluating price action. We look for price levels from which a stock is likely to move higher. These are levels from where the stock made a dramatic move up in the past. If the stock is in such a zone, we evaluate the probability that the stock will take off again from that level. We call our evaluation tools odds enhancers. If these factors are favorable we can enter the trade with confidence.

One of the odds enhancing factors we look at is the speed with which the stock moved away from the price level the last time it was there. In the middle of March ACT moved quite smartly away from the present level. So far so good.

There are several other odds enhancing factors that we consider; more than we have space for here. But one of the key ones is what kind of price action is happening as the stock approaches that level from which it earlier blasted off. Ideally it approaches the level quickly and without much hesitation. If so, it is likely that the reversal will be quick and decisive as well. If it meanders slowly into the level, the excess demand that we need to fuel a new launch can slowly burn off. The level might not give rise to a new upswing at all.

Unfortunately, this second odds enhancer doesn’t look very good with our ACT example. It had been in a sideways pattern for a couple of weeks, hovering just above the price level we were interested in. So even though the options payoff looked attractive, the likelihood of our getting that payoff was not good enough. We needed to look elsewhere.

The lesson here is that we need to do a thorough analysis on a stock’s likelihood of moving up or down before putting our money down for the trade. When we are trying to use options just for leveraged speculation we need to remember this – if it wouldn’t work as a stock trade, then it won’t work as an option trade.

Next time we’ll look for better candidates and look at zeroing in on just the right option for the job.