Stock options have always fascinated me. The idea that, if done properly, your returns would be measured in orders of magnitude, not mere percentage points.
Why Options Matter
There is always lots of talk about changing the world or saving the environment. However, if our individual or collective understanding of reality is not comprehensive and accurate, our efforts are misguided (if not pointless).
“Stock options”, may sound like a complex and dull topic. But upon closer examination, I see the following benefits to understanding the world of financial options and derivatives:
- For the ordinary “non-Accredited” investor (i.e. non-multi-millionaire), options offer one of the greatest avenues for gaining access to leverage leverage.
- Understanding options trading – and the larger ecosystem that is the wormhole of the global financial markets – gives us a higher vantage point from which to see the shortcomings of our existing system; as well as the ways in which it could improve.
There are few places where an individual can wield as much immediate power, or leverage, as within the world of stock options.
Intro to Options
Imagine you are investing in the stock market. Let’s say buying shares of a medium- to large publicly traded company. Let’s use the example of Amazon. Buying 100 shares, at $1,780 per share, will cost you $170,000.
Now let’s consider making the same investment, using options.
For $30,000 ($300 per share), we can buy a “call option” that gives us the right – but not the obligation – to buy 100 shares of at today’s price ($1,780 per share) for the next two years. If Amazon takes off, then we make as much money as normal investors who forked over the whole $170k.
We can also invest in a stock indirectly, by selling options. By selling a “put option”, on Amazon, we earn $26,400; and in exchange, we may be forced to purchase 100 shares of Amazon, between now and June 2021, at today’s price of $1,780. If Amazon’s share price takes off, the option expires worthless, and we get to keep the $26,400.
What is the nature of this sorcery? I’ve had to explain it so many times, that I’ve decided to simply publish a quick overview of options trading.
Stock options allow an investor or fund manager to manage risk & liquidity; leverage capital; and generate income; in ways inconceivable to most investors. In short, stock options are like term insurance contracts that offer a specific contractual benefit – the right (but not the obligation) to purchase or sell a given stock – for a fixed period of time, and are sold for a “premium” (i.e. price).
- Call Option: the right to buy stock (100 shares per call option)
- Put Option: the right to sell stock (100 shares per put option)
- When you buy a put option, you are “long” puts;
- When you sell a put option, you are “short” a put.
- As a seller (or holder of short) put options, we say someone “gets put” with stock (when the put buyer exercised the right to sell, and you as the option seller were forced to buy the shares)
- All options are purchased, and pertain to, a “round lot”, or 100 shares. Thus, any standard option, call or put, pertains to 100 shares
- “Underlying”: the stock to which a given option pertains (the “underlying” stock)
- Exercise: to “exercise” or execute an option, means to use your contractual right to buy stock (if you own a call option) or sell stock (if you own a put option)
- Strike Price: the price at which the option can be exercised. To exercise a call, you would buy the shares; to exercise a put, you would sell the shares
- Expiration: the date until the option expires
- Premium: the price per share per option. A premium of $7, means that the option costs $700 ($7 premium multiplied times 100 round lot)
- “Long”: “Long” stock, call options or put options refer to stock, calls or puts that you own. This is reflected by a positive quantity, such as “6 AMZN $1,780 June 2021 Call Options”
- “Short”: “Short” stock, call options or put options refer to stock, calls or puts that you sold (i.e. that you “are short”). This is reflected on your brokerage or trading statement, as a negative quantity; “-6 AMZN $1,780 June 18, 2021 Call Options”, means that this account holder has sold six such call options; and thus can be said to be “short” these six options
- Bull: “Bull” is used to refer to any strategy that has a net-long position on a given stock or security (i.e. is banking on its gain).
- Bear: A “Bear” position or “bearish” strategy, is one that has a net-short position on a given stock or security (i.e. is banking on its decline).
- “Naked” trading means the sale of uncovered options (in other words, selling call options without owning the underlying stock; or selling puts without being short the underlying stock). This is obviously a dangerous strategy, often referred to as “picking up pennies in front of a steamroller” (with the exception of “high-moat put writing”, i.e. writing puts on stocks you want to be buying regardless).
- Spread: A Spread, is any combination of options trades on the same underlying security. Because of the leveraged nature of options, most people who sell options, cover their losses by using a “Spread,” in which they buy options that partially-cover the downside of their strategy.
- Options Chain: The Options Chain is the list of options available. Generally, this is shown in a list format, with a selection at the top or bottom to choose which expiration you’re looking at.
Evaluating an Options Spread
Options are often used as “Spreads”. If I sell an Amazon put with a strike price of $1,780 (for a premium of $264 per share, or $26,400 per each option); and I buy a put with a strike of $1,400 at the same expiration (for a premium of $96.70, or $9,670 per option); I have entered into a “Bull Spread”.
In this scenario, I’ve created a maximum loss and maximum gain; I break even if Amazon ends up at $1,487 or above come June 2021. Based on the information I’ve given, you should now be able to understand everything below (with the exception of Implied Volatility, or IV, which I will get to later).
Created on Aug 29, 2019
Days to expire: 470
Interest rate: 0.05
Stock IV: 27.77%
Strategy Cost: credit $16,730.00
As of Aug 29, 2019
Underlying price: $1,786.40
Est. P/L: $4,348.40
|Short 1 contract @ 264.00||Jun 18, 2021 1780.00 put||credit 26400.00|
|Long 1 contract @ 96.70||Jun 18, 2021 1400.00 put||debit 9670.00|
Intro to Options: Basic Use Cases
To cover existing stock positions
A protective put, is a put option purchased for the purpose of protecting a long stock position against a decrease in value. If you bought 1,000 shares of Amazon at $1, and now have over $1m, you may not want to sell; but you may care to protect your investment against a market crash
To retain upside if you need liquidity, and have equity in a publicly traded firm
This is one of my favorite scenarios to help people with. There is always a way to generate income and/or cover your downside using options; these involve sacrificing degree of upside (by selling covered calls),
If you have spotted a solid short candidate.
A friend of mine was pitching his company to me, and told me about a stock called Massroots that was trading at a $70m valuation, with zero revenue (and a $250k monthly burn rate). I shorted this stock and did well; if it was optionable, I would have made a killing
Introductory Concepts for Options Trading
- Long-dated (LEAPs) options offer the greatest potential for returns (especially for those who aren’t day trading or swing trading). For high-volume stocks and major market ETFs (QQQ, SPY, etc) you can generally buy options up to around 700-1,000 days out; for smaller stocks, there may often only be options 6-24 months out.
- For a given stock, the rate of return on options, is generally highest for out-of-the-money (OOTM) options. An OOTM call option has a strike price above the market price of the underlying stock; an OOTM put option has a strike price below the market price of the stock. Because they are OOTM, they are lower in price; thus, they are high-risk (the stock must make substantial movement in the right direction in order for you to be “in the money”), and high reward. Let’s say XYZ Stock is trading at $85 today. If you buy 100 XYZ $70 1/1/2020 put options, priced at $0.50, that is going to cost you (($0.50 x 100) x 100) = $5,000. These 100 options correspond to 10,000 shares (100 x 100). If the stock goes “in the money” on an option of this price (ie, below $70), then each dollar the stock falls below $69.50, corresponds to $10,000 in profit (one dollar, per share of optionable stock, net of the $0.50 per share premium). Thus, if XYZ stock went to $59.50, you’d have an unrealized gain of $100,000, on a $5k investment. And that’s assuming that the option is at or near expiration; if the option doesn’t expire for months or years out, you’d probably be sitting on at least a few extra dollars of gains from the increase in the premium (the option may now be worth $4, up from $0.50, meaning your total profit would be around $135,000 if you sold it while it was still far from expiration)
- Thinly-traded options can be hard to sell; thus, for these, prepare to exercise
- Implied volatility provides a solid indicator of relative option price (higher the IV, higher the price of the option)
- “The Greeks” (Delta, Vega, Theta and Gamma) are a series of quantitative metrics that measure options’ sensitivity to changes in price (delta and gamma), time (theta) and volatility (Vega). However, thanks largely to sophisticated modeling tools, one can become an intermediate-level or proficient and effective options trader, without mastering these; as long as you can begin to understand how they are conceptually relevant. For me, learning
- Stock splits (and reverse stock splits) can cause a ton of problems for option holders, because your options are now “special circumstance” options, with a certainly lower market for resale. Even for an experienced trader, dealing with these has been a challenge. This is especially relevant for investments/trades concerning leveraged ETFs, which often split frequently
- Brokerage terms and the characteristics of a specific account type, and how it is configured, with what permissions, etc, will greatly impact your ability to trade. “Margin” and “portfolio margin” accounts are generally most effective for leveraged or higher volume options trading