Introduction to Basic Options Trading

Business Money
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Introduction to Basic Options Trading - Buying Call and Put Options

by Vertigo

Disclaimer: I do not claim to be an expert options trader. However, I have been doing it for awhile now and have been pretty successful. The purpose of this post is twofold: 1) To try to clear up some confusion for those of you who have tried to learn about options trading but found it too overwhelming, and 2) To introduce options trading to those who know little or nothing about it and perhaps inspire you to learn more and begin trading yourself. This is NOT intended to be a comprehensive masterpiece, so I would not recommend going out and trading options right after you read this. Do some more research as I promise there is a lot more to learn. Also, towards the end of this post I will get into some trading strategy. This is not intended to present my trading strategy as better than anyone elses. All I can say is that it has worked for me.

There are a lot of topics and terminology to be discussed, and I will attempt to present them to you in a logical order. Unfortunately, since I can only present one thing at a time, there may be some times when I’m talking about one topic and I’ll need to refer to something else that hasn’t been discussed yet. In these cases, just try to bare with me, as I’ll eventually get to the un-discussed topic. Also, this is probably going to get a little long, so if you’re having trouble following along, you might want to try just reading a little bit at a time, or read it more than once.

There are many different kinds of options strategies, some more advanced than others, but I am going to stick with the most basic of them (buying call and put options) since that is what I do and what I’m most familiar with.

AN EXAMPLE

Perhaps the best way to start this off is to give an example which illustrates the power and leverage of options trading. I will be referring back to this example throughout this post. Here we go:

Back on January 12 of this year I purchased 6 contracts of the February 45 call on CHAP (we’ll get into what all of this terminology means later - for now you just need to know that the underlying stock symbol is CHAP). At the time of the purchase CHAP was trading just above 44 dollars a share. The February 45 option was trading at 2.40. Here I must digress a little. Options are purchased in terms of “contracts” and in most cases 1 contract gives you the “control” over 100 shares. Therefore, 1 contract cost me 2.40 x 100 = $240 US dollars. I bought 6 contracts so my total cost basis was $1,440. 6 contracts gave me “control” over 600 shares of CHAP.

Now fast forward to January 29th. CHAP had gone up 5 dollars and was now trading at 49 dollars a share. The February 45 call option had gone from $2.40 when I purchased it on the 12th to $4.80 on the 29th. At this point, I sold off all 6 of my contracts back into the market (as opposed to “exercising” the options), at exactly double my initial cost basis. The stock was to go up even higher over the next week, but since I had already made a 100% profit, I was happy with the trade. So, to recap, I risked $1,440 dollars on the trade and made a total of $1,440 dollars less commissions on it in just about 2.5 weeks. I doubled my money, not bad.

Here is where we see the power of options trading. If I had been trading regular shares of CHAP, in order to make that same $1,440 dollars on the $5 dollar move that CHAP made from 44 to 49, I would have needed to buy 280 shares (1440 / 5 = 280). On January 12th, 280 shares would have cost me 280 x 44 = $12,320 dollars. Remember I only paid $1,440 dollars for the options contracts. Herein lies the appeal of options trading. You can make a decent amount of money rather quickly with a relatively small investment when compared to buying regular stocks. On the other hand, had CHAP gone down instead of up, I just as easily could have lost my initial $1,440 dollar investment in the same 2.5 weeks.

OPTIONS TRADING CAN BE VERY RISKY. In fact, before you can trade options, your broker will require you to fill out some paperwork and be approved to trade options. There are varying levels of approval which allow varying levels of options trading. The most basic level of approval will allow you to buy the type of options I will be discussing in this post.

THE BASICS

Ok, hopefully you were able to follow along with that example above. If you were confused, you should be able to go back to it later on after I’ve explained a few things and it should make more sense the second time around. In that example I showed you how I made money. Now we will get into WHY I made money on that trade. Let’s start off with some essential terminology:

Call option: An option contract giving you the right (but not the obligation) to buy an underlying stock at a given price (called the strike price). You buy a call option when you think the underlying stock will go UP in price. 95% of my trades are “calls”.

Very basically, and in terms of the example above, a call option does this: CHAP was trading at 44 dollars a share when I bought 6 contracts of the February 45 call. This means that, if CHAP were to go HIGHER than 45 BEFORE the expiration date of the option, I could “exercise” those options and buy 600 shares of CHAP at 45 dollars a share, even if CHAP was trading at 49 dollars a share (which it eventually went on to do), saving me 4 dollars a share. However, in order to exercise the options, you would have to have 600 x 45 = $27,000 dollars of cash in your portfolio to cover this trade. When all is said and done, you would have spent $1,440 dollars on the options contracts, $27000 dollars buying CHAP at $45/share, and you would own 600 shares of CHAP. Why on earth would anyone do this, you ask? Well, CHAP was trading at 49, and you were able to buy 600 shares at 45. You saved 4 dollars a share. 600 x 4 = $2400 dollars. Subtract the $1,440 dollars you spent on the options and you have $960 dollars of savings overall. Not a bad deal if you really wanted to own 600 shares of CHAP.

IMPORTANT: As opposed to exercising the options, most people will sell the option back into the market for a profit. I don’t need to have that 27 grand, nor do I own 600 shares of CHAP afterwards. All I have is the $1,440 dollars of profit I made on the trade. So, in this case, I bought 6 contracts at $2.40 and sold them back into the market at $4.80, which is a 100% profit.

However, if by the expiration date, CHAP was still trading below 45 dollars a share, the option would expire worthless and I would lose the $1,440 that I invested.

Put option: An option contract giving you the right (but not the obligation) to sell an underlying stock at a given price (called the strike price). You buy a put option when you think the underlying stock will go DOWN in price.

With a put, you make money when the stock goes down. Basically it is the opposite of a call option. Suppose when CHAP was at 44, I thought that it was getting ready to make a downward move. I could buy the February 45 PUT option, which would give me the right (if I owned them, which I don’t, but I can still buy puts) to SELL 600 shares of CHAP at 45 dollars, even if the stock went down and was only trading at 40 dollars a share. Again, instead of exercising the option (in the case of puts it would require that you actually own 600 shares of the stock) I sell the options back into the market at a profit. I do NOT need to own 600 shares of the stock.

Expiration date: All options have an expiration date. You must either sell the option back into the market, or exercise it, before the expiration date, or else it will expire worthless. The expiration date is always in terms of a given month, and options always expire the 3rd Friday of whatever month that is. (Well, technically it’s the Saturday following the 3rd Friday of the month, but the markets aren’t open that day) In my CHAP example above, the expiration date was in February.

Strike price: All options have a strike price. The strike price is the stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by the option holder when you exercise an option contract. In my CHAP example above, I bought the February 45 call. The strike price was 45.

Contract: Options are traded in units called “contracts”, which generally means 100 shares. So when you buy one contract, you control 100 shares. When looking at option quotes, they are in terms of 1 share. Therefore, whatever price is quoted, you need to multiply by 100 to see what the price would be for one contract. For example, an option quoting at $2.50 would cost me $250 dollars for 1 contract. 2 contracts would cost me $500 dollars.

In-the-Money: An option is in-the-money when the underlying security for that option is trading at HIGHER than the strike price of the option.

At-the-Money: An option is at-the-money when the underlying security for that option is trading AT OR CLOSE TO the strike price of the option.

Out-of-the-Money: An option is out-of-the-money when the underlying security for that option is trading BELOW the strike price of the option.

For example: When I bought the February 45 calls on CHAP on January 12, CHAP was trading at around 44 dollars a share. Since 44 was less than my strike price of 45, the option was slightly out-of-the-money at the time of purchase. Within a few days CHAP was trading at 45, so my option contracts were then at-the-money. By January 29th, when I sold my contracts, CHAP was trading at around 49, so my contracts were in-the-money. With puts, it would be the opposite. The February 45 put would be in-the-money when CHAP was at 44.

You might be thinking to yourself, what’s the big deal with this in, at, and out-of-the-money business? Well, in fact, it is a big deal. When an option reaches its expiration date, if it is not in-the-money, it will expire worthless. Why? Back to our example: Recall that I owned the February 45 call on CHAP and let’s pretend that I didn’t sell it on the 29th. Suppose that by February 16th (the third Friday of February – the expiration date of my options) CHAP was still trading at 44 dollars a share. And remember, my option contracts give me the right (but not the obligation!) to buy 600 shares of CHAP at my strike price. Well, my strike price is 45. Why would I exercise the options to buy 600 shares of CHAP at 45, when the stock is only trading at 44? The answer is, I wouldn’t. This will be reflected in the price of the option. This brings me to my next vocabulary term.

Time decay: As an option approaches its expiration date while still being out-of-the-money, the value of the option begins to decrease because the probability that the option will be in-the-money by the expiration date decreases. If your options are out-of-the-money, time decay accelerates as the expiration date gets closer and closer.

OK, at this point, I think it’s time for a picture, as it will give us a chance to see most of the above in real use. Let’s go back to my CHAP example. Below is a glimpse of some of the options trading for CHAP now. This is what you will see when you’re looking for options to buy.


Above you see the options available for two different expiration dates, February and March. There are more options available on CHAP but to keep the pictures small I just showed two months worth. Remember the options for those months expire the 3rd Friday of the month. There are NOT options available for every single month. They are always available for the month you’re in (unless it’s already passed the 3rd Friday) and the next month. Beyond that, there is a certain schedule of months that are available, which I won’t get into. In the middle of the the pictures you see the strike prices going down in a vertical column. Strike prices are available usually in increments of 2.50 or 5.00, but sometimes there are others, such as in the case of QQQQ where there are strike prices every 1.00. On the left side of the expiration date we see the calls, and on the right side we see the puts. See if you can find the February 45 call that I traded. Did you see it? It’s traded under the symbol .ZHQBI. You can see that it is now trading even higher than when I sold it. All options have a unique ticker symbol that you will need to know when making the trade. The first three letters in the symbol are always unique to the underlying stock (In the case of CHAP we end up with “ZHQ” because other stocks must have already had “CHA” or “CHP” or whatever) The last two letters in the symbol identify the expiration date and strike price of the option.

Also shown in the picture are two columns: Open Interest and Volume. Volume is the number of contracts traded that day, while open interest in the total number of contracts that have been bought since the options because available.

By the way, in case you didn’t know already, the ASK price is what you pay when you buy the option/stock, and the BID price is what you are paid when you sell it. So as you can see, the bid price is always lower than the ask, meaning that if you were to buy a stock or option and sell it one second later, you would lose money. In regular stocks, the bid and ask price are usually only a few cents apart. Unfortunately with options, they are always at least 5 cents apart, and more often they are 10, 20 or more cents apart.

Wow, that was a lot to digest. At this point, you might want to take a break to let this information sink in. We still have a lot more to cover.

CHOOSING THE RIGHT OPTION TO BUY

Now that we’ve discussed some of the basic terminology related to basic options trading, it’s time to get into how to choose the right option to buy. Choosing the right option to buy is just as important as choosing the right underlying stock. I will be referring to the terminology defined above and I will also need to introduce a few new terms.

So, how do we choose the right option? The answer is: carefully. Let’s just for now assume that you already know which stock you want to play options on. I won’t really get into how you did this, as there are numerous ways, such as: you got a hot tip from a friend, you subscribe to a newsletter that recommended a stock, you used some stock search engine which identified a strong stock. OK, so you have already picked a stock. For this example let’s say that you have reason to believe that the stock will be moving up in the near future, so you are going to be buying call options on the stock (not put options).

There are a few things we need to consider. To keep it simple, you need to be aware of:

  1. The price of the underlying stock
  2. How far away that price is from the strike prices available for the options
  3. What expiration dates are available

Now, before we go any further, now is probably a good time to go over how options are priced. Again, I will keep this simple.

Option Pricing: There is a specific (and somewhat complicated) formula that is used to determine how options are priced. In terms of call options, the lower the strike price is, the more the option will cost. For example, the February 40 call is more expensive than the February 45 call, which is more expensive than the February 50 call. Get the picture? With put options its the opposite. The higher the strike price, the more expensive the option.

The reasoning is this: option prices are somewhat based on the probability that an option will be in-the-money by the time the expiration date comes around. For example, say a stock is trading at 50 dollars a share 5 days before the expiration of all February options. If you own the February 30 call, which is 20 dollars in-the-money, there is obviously a BIG chance that in 5 days the option will still be in-the-money. The stock would have to drop 20 dollars/share in 5 days for it to be out-of –the-money. It could happen, but its unlikely. This option will probably cost somewhere near or above 20 dollars, so one contract would run you 20 x 100 = $2,000 dollars. On the other hand, for the same stock trading at 50 dollars a share, the February 70 call would probably only cost a few cents. Why? Because there is NOT a very good chance that the stock will go up 20 dollars in the next 5 days and be in-the-money at the time of expiration.

Also, the farther out the expiration date is, the more expensive the option will be. The March 45 call will cost you more than the February 45 call. Why? Remember options are based on the probability that it will finish in-the-money. The farther the expiration date is, the more time the stock has to move in-the-money. Also, remember I discussed time decay above? The farther out the expiration date, the less time decay in the option price there is.

So how do we put all of this to practical use?

Choosing the correct strike price: When choosing the correct strike price, you need to choose one where the stock can realistically be in the money by the time of expiration. You would most likely not buy options on a 50 dollar stock that are 20 dollars out of the money a few weeks before expiration (I.e. On February 1st, you wouldn’t want to buy the February 70 call, because its not likely the stock is going to go up 20 dollars/share in the next few weeks). At the same time, if you buy options that are too deep in the money, you will have to spend a lot more money because the options will be priced expensively. Typically, on a 50 dollar stock, I would be looking to buy at a strike price of 50, or possibly the 55 (but not likely) if I thought that the stock could go that high before the expiration date. Also very important to note: just because the option is in-the-money on or before the expiration date, it doesn’t mean you are going to make money. If you bought the February 40 call on a stock trading at 42, and the stock stays at 42 dollars, then the price of the option is not going to increase, hence you will not be making money. The stock needs to go up, bringing the price of the option up!

Choosing the correct expiration date: Just as important as choosing the correct strike price is choosing the correct expiration date of the option. Again, let’s assume you are buying call options on a stock you suspect will be going up in the near future. Generally speaking, you don’t want to buy expiration dates that are too close. At the same time, if you buy them too far out, you will have to pay more for the options. Just like when choosing the strike price, you need to find the balance between risk and cost.

95% of the time that I have lost money on an option play is because I bought an expiration date too close. I was predicting an upward move of the stock, but the stock took longer than I thought it would to make the move, and the expiration date came and my options expired. Within a few weeks of my options expiring, the stock would make the move that I predicted. Had I bought an expiration date farther out, I would have made money instead of losing it.

You need to examine the trend. Suppose that every few weeks it appears that the stock jumps up 3 or 4 dollars before pulling back again. Suppose further that I think this move will be beginning within the next few days. It is now February, so in my opinion, it would be too risky to buy February options. You only have a few weeks for the stock to make its move and you might get the timing wrong. Therefore, you need to look farther out. There will be March options because there are always options available for the next month. There may also be April or May. My rule of thumb is, take the time I think that the stock will need to make its move (suppose it usually takes 2 weeks to move up 3 or 4 dollars) and add that to whatever month it is now. Then buy options for the NEXT month that are available. So in February, I would be looking to buy March options if I thought the stock was definitely going to be moving up in the next few days or so, or else if I thought it might take longer than that to move, I would be buying April or May options. Again, you need to balance risk and cost. The March options will be cheaper than the May options, but perhaps March isn’t giving the stock enough time to make its move.

IMPORTANT NOTE: In case you haven’t figured it out by now, I am a swing trader. My plays are based on short term price movements. These movements are in terms of dollars though (i.e. 3 or 5 dollars or more depending on the underlying price of the stock), not cents like some day traders base their trades on. I do not make long-term plays. Generally I buy and sell within a few weeks or a month at most. So my logic in the sections above is based on the stock making a short term move and then selling right away after I profit. Therefore, I never buy options that are far out-of-the-money, and generally I only buy an expiration date that is 2-3 months out. (Also, I never buy an expiration date for the same month that I’m in.) However, if short term plays are not for you, you certainly don’t have to do this, and you can still trade options. You can buy the September options if you’d like, or the January 2008 options, or the January 2009 options. This is a strategy known as LEAPS, which you can look up online if you’d like to learn more. Of course, these options will cost you more. However, if the expiration is 2 years out, you can buy options that are farther out of the money (bringing the cost down some) if you think that the stock will be going up over the next 2 years. It is for you to decide if it is worth it.

DIGGING EVEN DEEPER NOW

Ok, back to business now. There are still a few things to go over. As I mentioned earlier, even if your option is in-the-money at the time of expiration, you won’t necessarily make money. If the stock price stayed the same throughout the time you owned the option, the option price will stay basically the same as well. On the other hand, just because the stock hasn’t reached the strike price yet, it doesn’t mean that you didn’t make money either. Another example, followed by some more tricky concepts:

Suppose there is a stock trading at 45 dollars a share and I have good reason to suspect it will be going up 5 dollars in the next month or so. (By the way, I keep making references to suspecting that a stock will be going up. How do I know this? Well, I don’t, but it’s an educated guess. I will be writing a second post in the near future describing how I arrived at this guess. I am not getting tips from insiders, if that’s what you’re thinking.) OK, so say I bought the May 50 call of that stock trading at 45 (typically I wouldn’t do this as its too far out-of-the-money, I’d buy the 45 call instead, but for the sake of example say that I did). Low and behold, the stock begins to make its move, but it doesn’t go as high as I thought it would. It went from 45 to 49 (still out of the money) and now it appears that the stock will be coming back down (Again, why I suspect this will be described in my second post that I will make soon). The stock went up 4 dollars a share, and so the option increased in value as well. At this point I could do two things. I can sell my options for a profit, or I can hold onto it. If I hold onto them, the stock might come back down, but since I bought the May options, I still have time for it to go back up. Generally speaking, I do option 1, which is sell the options. I don’t like to see my profit going down, so I don’t like to hold onto an option as it loses value, even if I think that it has a good chance of going back up in the future sometime before the expiration date.

Before going further, we must get into some more advanced materials. You don’t necessarily need to master this stuff, but you should be aware of it.

Delta: Delta is what is known as an “option Greek” and is a value between 0 and 1. On your online brokerage or stock site, you should be able to look up what the delta is for a given option. Here is how delta works. As the price of a stock increases (or decreases) the price of a given option will increase (or decrease) by delta. When an option is at-the-money, the delta will be .5. This means that that when a stock is trading at 45 dollar/share, the options with a strike price of 45 will increase by 50 cents for every dollar that the stock moves. The farther and farther that the option is into-the-money, the higher the delta is. A stock that is 20 dollars in-the-money will have a delta approaching 1. As a stock moves farther and farther out-of-the-money, delta will decrease and approach 0. A good way to think of delta is the probability that the option will be in-the-money when the expiration date comes.

There are a few other option Greeks. I won’t get into them in detail but I’ll mention two briefly. Gamma is a measure of the change in delta as the stock price moves. As I said above, as a stock moves farther into-the-money, the value of delta will increase. It increases by the value of Gamma. Theta is a measure of time decay. You lose money to time decay on out-of-the-money options by a value of Theta, which increases more and more as the expiration approaches.

OK, now back to my example above. I bought the 50 call on a stock trading at 45 dollars/share. The stock made a short term move that brought it up to 49 dollars a share. Even though my options are not in-the-money, I can still make a profit if I sell now. As the price of the stock rose 4 dollars per share, the value of my options increased by the ever-changing delta. Since my options were initially 5 dollars out-of-the-money, the delta was very low. However as the stock got up to 49 dollars (a few months before my expiration) delta began to increase. Still, delta would be less that .5 at this point. Meaning that even though the stock moved up 4 dollars, my options moved up less than 2 dollars. Again, I could always hold onto the option, even though I thought in the short term it would be going back down, as long as I thought it had a chance of jumping back up before the expiration. I typically would not do this, however. If I had good reason to believe that the drop in stock price was a short term thing and would be going up again soon, I would sell my options as the drop started, locking in my profit, then buy more options again as the stock bottomed out before rising again. This way, I avoid going two steps forward, 1 step back, then two steps forward again. (3 steps forward total). Buy selling at the top then buying again, I go two steps forward, sell, wait, buy, then two steps forward again (4 steps forward total).

GENERAL STRATEGY and MISCELLANEOUS

  1. Above I made up an example of buying the 50 dollar call on a stock trading at 45 dollars a share. Realistically, I personally would never do this. I don’t buy options that far out-of-the-money, unless I were buying it many, many months away from the expiration date, but I generally don’t like to do that either. The reason being, the delta is very low. So even if the stock moves up a few dollars, the price of my option will not increase very much, therefore my profit would be limited. On a 45 dollar stock I would typically buy the 45 call.

You need to think very carefully about which strike price you buy, and as I mentioned earlier on in this post, one thing to consider when choosing which option to buy is the price of the underlying stock. Say a stock is trading at 47.50. I might find that the 50 calls, while cheaper, are too far out-of-the-money, while the 45 calls are in-the-money but they are too expensive for my tastes. Perhaps in this example, even though the stock looks good, I might move on to something else. Perhaps I might buy the 45 call, but end up getting less contracts than I normally would because of the higher price.

  1. Another thing I should mention has to do with expiration dates. I almost never hold an option all of the way until its expiration date. I buy the expiration date 2 to 3 months out and after the stock makes the move I believe it will make, I sell my options, even if the expiration is still 2 months away. The only time I’ve held onto an option up until the expiration date was earlier on when I was buying closer expirations because they were cheaper, and the stock took too long to make the move I thought it would make.

Remember, when you buy options on a stock, the stock can and sometimes will move the opposite direction that you want it to move. You can lose a lot of money very quickly. I’m not going to get into portfolio management strategies, but just like in regular stock trading, stop loss order should be placed. If you forget to place a stop loss, and your options are down to the point of being almost worthless, you might also hold onto them until the end of the expiration on the chance that some miracle could bring the stock back up.

  1. When an option reaches its expiration date and you still own it a few things can happen. First of all, if the option is out-of-the-money it will expire worthless and that will be the end of it. Come Monday, it won’t be in your portfolio anymore. If the option is in-the-money at expiration, you will have to check your brokerage for what happens. Some may try to automatically exercise the option on your behalf, assuming you have enough money in your portfolio to cover the buy for a call, or own the stock to sell for a put. Other may sell the option back into the market for you, as opposed to exercising it. Again, check with your brokerage. Like I said, I generally sell right after the stock makes its move and almost never carry an option until expiration.

  2. Earnings announcements: This relates to options as well as regular stock trading. Always make sure you are aware of when a stock is making an earnings announcements. I almost never buy options on stocks that will be releasing earnings while I own the option. The reason being, the stock price can and usually will move significantly in one direction or the other following an earnings report. This can be great if the stock goes up and you own a call. However, you can lose a grand or two in a matter of minutes if you’re wrong.

With that said, consider this. There are a lot of factors which come into effect when a company releases earnings. The company could beat analysts estimates by a mile, yet have some predictions for the next quarter which are less than favorable. Therefore, you could be buying call options because you think the company will beat the analysts, which it did, but the stock will end up going down anyway. This has happened to me a few times, which is why I stopped making earnings plays. Also, you could be totally wrong about the earnings, thinking they will exceed analysts estimates, but they report way lower, and the stock plummets.

  1. After hours trading: You can’t trade options after hours like you can regular stocks. Some stocks move a great deal after hours, especially on earnings announcements released after market close. Therefore, if you have options on a stock that moves after hours, you won’t be able to trade it until the next morning when the options market opens. This comes into play on times such as bad earnings. You might be sitting there watching your streaming quotes as the stock drops 1 then 2 then 3 then 5 dollars. You just lost a whole lot of money. Had you been able to trade after hours, you would have been able to sell your options when the stock just started to drop after the bad earnings came out. However, you must wait until the next morning, after the option has lost most or all of its value. Just something to be aware of.

  2. Not all stocks are optionable. Some stocks do not have options available on them for trading. You will have to find the ones that do, which isn’t hard at all. When you look up a stock on whatever brokerage site you use, you will see a link that says something like “Optionable” or “Options” or “Options Chains” or “Chains” or something like that. Click on that link to show the options available. If you don’t see that link, the stock is probably not optionable.

TO SUM UP

OK, hopefully you’ve made it this far. I covered a lot of material and you might want to review it more than once. Again, I’d like to stress that I don’t think I’ve provided you with enough info to go and start trading call and put options right now. I would suggest that you take what you learned here and go pick up a book or look online for some more info. There is still a lot to learn, but I think I covered the basics for you.

This last section is just a basic summary of what I do when choosing an option to buy. This strategy has been working well for me.

  1. Identify a strong stock. 95% of my trades are call options. I’m a bull. Therefore I do searches that identify strong companies, then I look at their chart. I like to see stocks that have been in a strong uptrend for at least the last 6 months to a year. When I see that, then I examine the chart pattern. I’ll pull up a chart of the stock with its 30 day moving average. I’m looking to see a pattern of the stock “bouncing” up and down off the moving average as it gradually moves up. (More on this in a future, yet-to-be-written post).

  2. Look at the price of the stock. Generally I like to play options on stocks that are between 30 and 60 dollars. Stocks cheaper than 30 tend not to move as quickly, meaning the options will not move as much either (though the options will be priced relatively cheaper). The more expensive a stock is, the more expensive the options are for it. If you don’t believe me, look at the prices of options for Google (ticker: GOOG). Stock under 60 dollars tend to have option prices that are just right for me.

  3. Make sure the stock isn’t releasing earnings in the near future. You can always try earnings plays, but in my opinion they are too risky. There have been times where I’ve made $1000 dollars in a matter of minutes. On the other hand, there have been times when I’ve lost nearly that much in the same amount of time. Even when the company beats analysts expectations (which you have to guess that it will do) the stock may still plummet. I stay away from earnings plays.

  4. Look at the strike prices. I went over this in detail earlier in this post. Basically, I’m looking to find an option that is only slightly out-of-the-money, at-the-money, or slightly in-the-money. Remember, even though they are cheaper, the farther out-of-the-money the option is, the lower the delta is, so even when the stock moves, the option won’t move very quickly. Also, very deep in-the-money options are expensive. So you need to find a balance between cost and risk. Typically on a 45 dollar stock, I would buy the 45 call. On a 47.50 dollar stock, I would buy the 45 call. On a 49 dollar stock, I would buy the 50 call.

  5. Look at the expiration dates. I went over this in detail earlier too. Even though they are cheaper, you don’t necessarily want to buy an expiration date that is too close, because the stock might not move when you expect it to. As I’ve said, the majority of times I’ve lost money on options trades is because I bought an expiration date too close to save money, and the stock didn’t move when I thought it did. After my options expired, the stock went up as I predicted it would, but I no longer owned the option. Ever since I started buying farther out, I’ve been successful. I typically like to buy an expiration date 2 to 3 months out, even if I think the stock will make its move within the next few days.

  6. Time the buy. Just because a stock has been doing good all year it doesn’t mean that now is the time to buy. Look at the chart for a stock that has been uptrending all year. It is going up in a straight diagonal line? Most likely its not, though some stocks do. Typically, however, you will notice a pattern of the stock moving up in “bounces”. Typically these bounces can be seen when you look at a chart with the 30 day moving average displayed. In short, you don’t want to be buying options when the stock is at the top of one of these bounces. This is when you want to be selling it, meaning you have to buy the stock at the botton of one of its “dips”. (Again, all of this will be discussed in much greater detail in a future post I have not written yet.)

  7. After the stock makes its move, and the options have become profitable, I sell the options back into the market, like the majority of options traders do. I NEVER exercise the options. You can if you want, but in the case of calls it would mean you’re buying a few hundred shares of a stock (which requires that you have enough cash in your portfolio to do) and in the case of puts it requires that you already own a few hundred shares of the stock.

CONCLUSION

As Forrest Gump said, “That’s all I have to say about that.” Hopefully you learned something from this and I’ve inspired you to learn more. If you were confused while reading this, don’t worry, this stuff can be a bit complicated at first. Maybe try reading it again or look elsewhere online to fill in the gaps. Also remember that there are many different options trading strategies, such as covered calls, and spreads. I just went over the basics of buying put and call options here, but there are other ways to trade options.

If you have any questions, ask away, but please don’t quote back this whole post!

P.S Next I will be working on a post which describes my method for finding good stocks to trade and how I time the buy and sell. I promise there will be more pictures next time. :slight_smile:

2

sweet! Thanks Vertigo.

3

Happy reading :slight_smile: Did that help clear up anything for you, or did I make it worse?

4

This is feckin’ brilliant! Thanks for the time/effort in writing this up.

Cheers :slight_smile:

5

Wow, that’s awesome! :bravo: :notworthy:

Thanks a lot. I’m printing it out and look forward to reading it later.

6

Happy reading :slight_smile: Did that help clear up anything for you, or did I make it worse?[/quote]

I’ll read it at home, on the terlit, my thinking place. :slight_smile:

7

If the… terlit is your thinking place, what does that make Forumosa.com?

8

If the… terlit is your thinking place, what does that make Forumosa.com?[/quote]

My home away from work.

9

Happy reading :slight_smile: Did that help clear up anything for you, or did I make it worse?[/quote]

Well, I’m into part one and I am VERY clear now. The reading I did last year didn’t make a mark, but your writing does.

I guess the only reason to exercise a call would be if the stock shot through the friggin roof.

This is good shit Vertigo. If you make it to Kending over CNY you’ve got a beer from me. :slight_smile:

10

I’m glad to hear this was helpful to everyone. If you have any questions, feel free to ask away.

[quote=“jdsmith”]Well, I’m into part one and I am VERY clear now. The reading I did last year didn’t make a mark, but your writing does.

I guess the only reason to exercise a call would be if the stock shot through the friggin roof.

This is good shit Vertigo. If you make it to Kending over CNY you’ve got a beer from me. :slight_smile:[/quote]

The only reason to exercise a call option would be if you really wanted to own the stock outright because you believed it was a good stock and you wanted to hold onto it. So yes, you’re right in that the stock would need to shoot up first to ensure that your option was now in-the-money (if you purchased it out-of-the-money) before attempting to execute it. In the case of CHAP, I had no interest in owning 600 shares of the stock (and I certainly had no interest in spending $27,000 on those 600 shares) hence why I just sold the options back into the market. Most options traders do not exercise the options, they just sell them for a profit.

When you exercise a call option, you don’t actually “make” any money, you just save some money because you bought the stock at a discounted price. In fact, in the CHAP example it would cost you 27 grand. Now, if CHAP continued to move up after exercising the option, you would make money on the 600 shares you own. However, if it went down, you would then lose money.

Many thanks for the beer offer, but with any luck I will be in Malaysia for CNY on a business trip for 6 weeks. :slight_smile:

11

If the option expires, you lose the money you put out to buy the option though, yes?

12

Yes and no.

If your option is out-of-the-money, as the expiration date gets closer and closer, the value of your option begins to decrease because of time decay. Say you bought the option when it was at $2.50 one month before the expiration. Time decay increases exponentially as the expiration approaches, to the point where, if your options are far out-of-the-money, your option will be worthless. So a few days before expiration, if the option is still out-of-the-money, the option would have gone down to say, $0.10 for example. Therefore you would have lost 240 dollars per contract at this point. Once the option expires, it will cease to exist in your portfolio and you would have lost all that you invested. But its not like all of the sudden one day you have 1000 dollars in your portfolio and the next day its down to 0 after expiration. You would have been losing that money gradually day-by-day as expiration approached as the option price went down if the option failed to move into-the-money.

If, on the other hand, the option is in-the-money on the day of expiration, you’ll have to check with your broker to find out what happens. As I said, some brokers may try to exercise the option on your behalf if you have enough cash in your portfolio to cover buying however many contracts worth of shares you had call options on. Other brokers may just sell the options for you back into the market. I would suggest that you don’t let this happen, as you should always make the trade yourself.

Does that make sense?

13

Vertigo, how do you handle money/portfolio management issues?

14

Conservative traders will tell you to never risk more than 1 to 5% of your total portfolio value on any one trade. If you have a portfolio worth $20,000 dollars, this would be $1,000 dollars per trade if you went by 5%. If you went by 1% this would be only $200 dollars. With $200 you might be able to buy 1 or 2 contracts of really cheaply priced (and most likely out-of-the-money) options, and in my opinion this would not be an effective way to trade options.

On the other hand, someone just starting out trading might open up an account with an initial $2000 dollar cash deposit. 5% here would only be $100 dollars. Again, this is not nearly enough to trade effectively. With $100 dollars you wouldn’t even be able to get 1 option contract on most stocks, though I can think of a few that you could buy.

Personally, when I make a trade, I usually put at least $800 dollars into it and sometimes as much as $1500 or so. Depending on the stock, this might get me anywhere between 3 to 10 contracts. The choice to put more or less money into a play is determined by my level of confidence that the trade will go favorably for me. I only buy options on stocks that have been trading in a predictable pattern for 6 months to a year. However, even when the pattern is somewhat predictable, some stocks are more volatile then others. The more volatile stocks will get less money invested into them while the less volatile stocks will get more.

Regardless of if you have a $2000, a $20000, or a $100000 dollar portfolio, the most important thing to remember is, never risk money that you can’t afford to lose.

I always trade with a stop loss order set. A soon as I buy the options, I set my stop loss order at a 50% loss. As the stock moves up, I adjust the stop loss with it. But you can’t set the stop loss too close to the stock price, because you don’t want normal intraday price fluctuations to trigger the stop loss prematurely. For example, a stock might open in the morning and be down 75 cents within half an hour, but by market close it is up $1.50. If your stop order was set too close to the open price, it would have been triggered in the morning when the stock initially dropped.

On the other hand you don’t want to set your stop too low. Generally as the stock rises I raise the stop loss price with it keeping the spread between the stop price and the stock price about the same. As the stock starts to get to the point where I think it is at the top of its “bounce” and might start to go down, or maybe continue to go up, that is when I start getting aggressive with setting the stop loss closer, especially if I’ve already achieved a significant profit at that point.

I never have more than 2 or 3 trades going at one time. Sometimes I only have 1, sometimes I have 0. The reason being, if I have a whole lot of money on bullish call plays, and all of the sudden something happens that negatively effects the market (such as the Fed raising interest rates again) I could end up losing a lot of money on several different plays at once.

Another thing is, and being in Taiwan probably not everyone will have this luxury, but I work at night from home on my computer, and I generally do not get to bed until 3 or 4am local time. This means that I’m up the majority of the time the US markets are open, so naturally I have my streaming quotes running and I’m constantly monitoring my positions.

In addition to monitoring the chart for the stock you have positions open on, you need to also monitor the major indexes. If I have options on a stock that trades on the NASDAQ for example, I will examine the chart for the NASDAQ much as I would the stock. If the stock appears to be getting ready to bounce up, but the NASDAQ appears it is going to come down, I stay out of the play. Always trade with the trend. “The trend is your friend” so they say. It is for this reason that after I get out of trades I will often not have any plays going for two weeks or more. I’m waiting for the major indexes to get back into a bullish run. Of course, during these pullbacks I could very well be buying puts, but in my opinion it is a lot harder to find stocks which look favorable for put plays.

A lot of amateur traders will get out of a succesful trade and because they just made money in the market, they are very eager to get back into another trade right away. This is potentially a recipe for disaster, especially when making short term trades. The previous trade could have been successful for a variety of reasons, one of which could be that all of the major indexes were making bullish advances. After getting out of the profitable trade, this person may rush into something else without being aware that even in bullish markets, everything always pulls back to support at some point. Hence, the second trade might be an utter failure causing the person to lose all of the money he made in the first trade. Always trade with the trend!

15

I have a question V. How many hours a day would you say you need to spend to do this on a regular basis? You know, keep up with everything and whatnot. I understand that it can be as little or as much as a person wants it to be, but to do it and be successful, there must be some “average” number.

1 hour, 2, 3, 4 hours a day?

16

In all honesty, you don’t need to spend that much time. A few hours a week I would say. The routine would typically go something like this:

  • First I need to find some stock candidates for trades. There are many ways of doing this, for example you might get a tip from a newsletter you subscribe to, or you read an article, or you use your online brokers search tools to find strong companies (this is what I do). This process is not very time consuming at all. It doesn’t take long to read a newsletter, nor does it take long to run a search. A couple minutes are spend on this step. (On a side note, you can’t believe everything you read in a newsletter, so always do your own research on a company if you heard about them through a newsletter.)

  • Once I have identified some strong companies I will start looking at their charts to identify favorable patterns. As I’ve said, I mostly trade calls so I look for a stock that has been uptrending for 6 months or longer and I’m looking for stocks that “bounce” up and down in a somewhat predictable pattern as it gradually uptrends. Looking at the charts I’m able to narrow down the field to a handful of potential candidates. This process could probably be accomplished in an hour once a week or so.

  • Once you have some strong candidates, then you need to spend a little bit of time to determine which option you are going to buy, i.e. which expiration date and strike price seem the most favorable. This process doesn’t take very long at all (a few minutes) because I know exactly what I’m looking for.

  • So by now I know which option on which stock I want to buy, but that doesn’t mean now is the time to buy. So what I do is put the stocks all in a watchlist. Then I spend a few minutes each night looking at the charts to determine when is a good time to buy. Again, I know exactly what I’m looking for, so this doesn’t take long at all either. A few minutes each night maybe.

  • When it appears that it is time to buy, I make the trade. Now in my case, when I have open positions, I tend to watch the streaming quotes quite a bit, but this is because I’m awake and on the computer anyway. You certainly don’t have to do this though. This is not day trading where you would be buying and selling the same day and therefore having to monitor your positions constantly. My trades are based off of short term stock movements that generally take one week to three weeks to happen. So when you have an open position, you really only need to check on them once a day, typically after the market has closed. After a week or two when you determine it is time to sell, you put in the sell order, and exit the position.

So really, I don’t think it requires that much time. If someone is just starting out they may want to spend more time on it obviously, but once you have some experience you will know exactly what you are looking for and it won’t take you long to spot it. If you subtract the time I spend monitoring the streaming quotes, I probably only spend an hour or two each week doing research and determining what I want to buy. Lately, I’ve been spending even less time on research because there are a few stocks that I’ve been trading over and over again, so all I need to do is look for buy and sell signals. Of course, I’m always looking for new opportunities so I will still run a search once a week or so to find them.

17

I know I keep mentioning that I’m looking for stocks that “bounce” as they move up. If you’ve never noticed this phenomena, here is an example of what I mean when I say that. You can see that the stock is gradually uptrending but it is not moving in just a straight diagonal line. The red line is the 30 day moving average. Trading on bounces like this is just one of many different trading strategies out there.

This picture is just an example and I would never make a trade just based on looking at a chart like this alone. There are various technical indicators/studies that I use to help determine when this bounce will occur. I will go into them in more detail in a future thread. The arrows I drew in indicate the time to buy and you can probably guess when the time to sell would be. Again, the technical studies would help to determine when that is.

18

Hey Vertigo, here’s an interesting real life situation I am facing. We own a substantial amount of MO. MO will spin off Kraft next month, giving me .7 shares of Kraft for every share of MO we own.

I read this:

[quote]The hedge is on shares of Kraft Foods Inc. that Altria shareholders are about to receive. Altria will spin off its stake in Kraft next month, giving investors 0.7 share of Kraft for every Altria share they hold.

Excitement about the move, which was announced last week, has helped lift Altria’s shares about 13% since the third quarter, as the company overcame barriers to the spinoff.

Shares of Kraft, on the other hand, have lost nearly 5% in the four months as the company has faced competition and cost pressures.

So it is understandable that Altria shareholders might not be that interested in keeping the shares of Kraft they are due to receive, and that has some expecting that a flood of stock for sale will cause a notable decline in Kraft’s share price. “More than $50 billion of Kraft equity needing to find a home all at once will likely cause an extended oversupply of the shares,” D.A. Davidson analyst Timothy Ramey said in a recent note.

Investors worried about this should “go out and buy puts even though they don’t own the stock yet,” said Joseph Palazzola, options strategist at A.G. Edwards & Sons.

By doing so, investors can lock in Kraft’s current $34.03 share price – less the cost of the puts, of course.

Buying any option entails an investor being prepared to lose all of their money since when you buy an option you do not actually own anything. It’s value is based on the difference between the strike price of the option and the price of the stock it tracks. In theory you could go to lunch, have good news make the stock jump and be left holding an option worth nothing in this case.

Add to this options trade on supply demand just like other securities so the price you will be paying for these suggested puts will be expensive. Short term options trading is very volatile and if you cannot watch these trades you could lose your whole bet (notice I said bet and not investment, short term option trading is just that, betting not investing). Unless you own at least a thousand shares of MO and would be receiving 700 Kraft shares, after you figure in transaction costs, the risk you are taking on vs the potential reward is just not worth it.

I will not do any of this. I will take my spin off, be happy and not get greedy.[/quote]
biz.yahoo.com/seekingalpha/07020 … .html?.v=1

So Kraft is expected to drop once the .7 spinoff is done as the market gets flooded with Kraft shares. Buying a put on Kraft would be wise in that A) we would still own the shares we get and B) we’d make some dough as Kraft’s shareprice drops?

I am one not hapy with the spinoff, as I don’t own MO for Kraft and would rather stay ALL invested in MO. My options, haha, are to sell my KRAFT shares and buy mo MO, or sit on them and see if they go up? But the dividend for Kraft is not attractive to me. I own GTY and ALD for juicy dividends and a piddly 3% just doesn’t float my boat, that, and I do not expect them to shoot up in share price anytime in the near future.

What’s your take on all this fiddledeedee?

19

As the shares of Kraft drop, you would in fact be making money on the puts. But you have to remember that you’d be losing money on the Kraft shares at the same time. It’s difficult to say whether or not buying puts would cause you to break even on the falling price of Kraft, or if you’d come out ahead. I think it would all depend on how much Kraft dropped, how many put option contracts you bought, and the price of the puts. If there are a lot of people buying them, as their appears to be in this case, the price of the options may get bid up to the point of being overvalued. There are a number of factors that determine the price of an option. I didn’t get into this in my original post other than mentioning that there was a complicated formula to determine it. Volatility is one of the factors, and volatility will often get bid up in anticipation of major events such as the one you’ve described. It’s a tough call to make, as trading on news often is. As the article you quoted says, you can go away to lunch and some news might come out and all of the sudden the stock shoots up.

It looks like there was a lot of action on the March 37.50 put on Friday, and there is a lot of open interest on the March 35 and March 30 puts. Far more so then on any of the calls for that month. So people were betting that Kraft would fall, but in the case of the 37.50 and 35 that doesn’t mean they believe it’s going to keep falling (since those puts are already in-the-money now and I don’t know how long ago they were purchased). I guess the only thing I can say is that if you believe Kraft will continue to fall below where it is now, puts might be a good way to hedge your position. They might even prove to be a good exit strategy for getting out of your position in Kraft if you chose to exercise the options. Then again, if Kraft went up, you would lose money on the puts but gain money on your position of Kraft. Again, whether or not you would lose or profit or break even from this would depend on how much the stock moves, how many put contracts you bought, and the price you paid for those contracts.

20

yeah, i figured it would work like that. lol

i’ll just hang on to them for 6 months and try to dump them then.

i hear the pancake wrapped sausage is doing well.