Home > Stock Market Analysis > Options: What they do and how to trade them

Options: What they do and how to trade them

tl;dr version: Fundamentals teach you what to trade, technicals teach you when to trade.

Much has been written online about options, so some of this won’t be novel information, but I’d like to discuss some of the things I learned as I was learning about the stock market.  I’ll admit, learning about options was incredibly daunting; one look at a stock’s option chain ($AAPL, for example) is overwhelming at best.  But options are a great way to leverage relatively small amounts of capital for large gains.  My favorite sites for explaining options and different option strategies are The Options Guide and Option Trading Tips.

In short, buying stock options gives you the right, but not the obligation, to purchase shares of an underlying asset at a specified price (known as the Strike Price).  They are an amazing way to leverage your portfolio to make a higher percentage increase on your investment with every smaller percent increase in the underlying asset.  For example, a small increase in a stock can result in a much larger increase in the option associated with that stock.

When buying normal shares of stock, owning 100 shares of a stock priced at $100, means you’re holding $10,000 worth of shares.  Let’s say that stock price goes up to $105.  It’s now worth $10,500.  Ok, cool, we just gained $500 or 5%

Now instead of owning the stock itself, let’s say we buy 100 call options priced at $1.00 with a strike price of $110.  Keep in mind each call option is “bundled” with 100 contracts, so buying 100 call options (with each option containing 100 contracts) at $1.00 is worth $10,000.

A rise in the underlying asset some amount will result in the call option price to go up.  So let’s say the underlying rises to $105, the call option may rise up to $2.00, possibly more.  At an option price of $2.00, our 100 contracts are now worth $20,000!  We just doubled our investment.  Or realized a 100% gain.  This is the beauty of options.

There is one caveat with options and that is Time Decay, represented by the Greek letter Theta.  In order for an option price to rise, the underlying asset price MUST move (up for Calls, down for Puts).  If it doesn’t, your option price just starts to fall until expiration.  If your option reaches expiration without being “In the Money” (above the strike price for Calls, below the strike price for Puts) it will be worth ZERO.  In other words, your loss will only be what you initially paid for the option in the first place.

I like graphs, so here’s a graph constructed in Excel using OptionEdge’s option trading software (it’s free, I like free).

Call Option Graph, courtesy of http://www.oedge.com/index.php

In our example, we spent $10,000 on 100 options priced at $1.00 at a strike price of $110.  The green line represents our current profit/loss potential.  As you can see, when the price of the underlying rises to $105, the option value is $20,000.  If we were to sell, the option would be worth $20,000, thus making $10,000 in profit.

The red line represents what the option is worth at expiration, also known as the intrinsic value.  If the underlying asset fails to reach the strike price of $110, our option is worth nothing.  So going back to our example, let’s say our 100 call options are at a strike price of $110.  But by the expiration date, the underlying stock price only went from $100 to $105.  It’s a 5% increase from where it was, but still not good enough for our option to be In the Money.  So our 100 contracts that we had bought for $10,000, doubled to $20,000, are now worth a big fat $0 because we held on to them for too long and they kept going down in price due to the Time Decay. Bummer.

In other words, when buying Calls or Puts, the maximum profit is unlimited, while the maximum loss is only what you spent on purchasing the option initially.

The difference between the green and red lines is the extrinsic value of the option, also known as the premium.  As the expiration date nears, the price of the option decays and the green curve begins to look more and more like the red curve.

Option Price as Function of Time to Expiration, From http://www.optiontradingtips.com

There are other risk measures to keep in mind when trading options, known as The Greeks.  Two important Greeks to understand, besides Theta, are Delta and Gamma.  Delta is a measure of how much the option price changes in response to a change in the underlying.  Gamma represents Delta’s rate of change, that is, how much the rate of change of the option price changes with movements in the underlying.  A detailed look at Greeks is beyond the scope of this blog, but it is important to understand how these metrics affect your profit and loss potential.  Check these resources to learn more: ThinkorSwimInvestopedia, and The Options Guide.

There’s some really interesting strategies one can employ when trading options.  Many are described at The Options Guide.  You can buy (and sell! – but I won’t go into selling options on this post) both Calls and Puts at varying strike prices and at varying expiration dates lending to some pretty complex trading schemes.

Ok, so great, that’s all well and good, but how do you trade them?  Simple.  Pattern recognition.

As you may have noticed in my previous blog posts, I like to do a lot of technical analysis.  Technical analysis might be a dying art, but it helps to try to pick bottoms and tops and predict swings.  It’s pretty remarkable to me how faithfully stocks can follow trendlines and areas of support and resistance, so I try to use the general trends as guidelines for when to enter and exit.  This leads to a lot of tape-watching for the right entry or exit point.

My golden rule is fundamentals tell you what to invest in, technicals tell you when to invest.  For instance, if I notice a stock that has attractive financials (or unattractive, for the bearish traders) has bounced nicely off a trendline, there’s a good chance that will be the bottom (or top) and I’ll buy calls (or puts) accordingly. If I’m almost certain of a price move, I’ll load up on near term OTM/ATM options, which could be an insanely foolish strategy because of the high Theta, but sometimes most lucrative due to the high Gamma, and therefore highest percentage increase in stock option price (relative to other ITM or deep OTM options).

I like real-life examples, instead of made-up scenarios, so here’s one.  A few months ago, I bought 60 AAPL call options for $18.15 with a strike price of $570.  With commission, it cost me $109,024.  When I bought it, AAPL the stock was trading around $568.  When I sold the 60 options the following day, Apple made a move up to $583.  I sold the 60 options for $29.50, now worth $176,875.  A 60% increase. I’ll take those returns any day.  Ok, so I left some profits on the table because after I sold my options, AAPL continued to go up and closed the day at $589.  Those April 570 calls were now worth $37.00.  I missed out on $45,000 of profits because I sold too early!!  But who knows, maybe AAPL could have completely crashed (just look at Feb 15th… aapl rose from 500 to 526 then crashed down to 499).

But this represents my strategy when trading options.  I’d much prefer to take profits than to risk my options being worth nothing if the stock drops or decays into nothingness.

Let’s look at another example.

AAPL Daily, freestockcharts.com

AAPL Hourly, freestockcharts.com

S&P 500 Daily, freestockcharts.com

S&P 500 Daily, freestockcharts.com

S&P Hourly, freestockcharts.com

AAPL has been, for the most part, stuck in a medium-term descending trading channel since the highs in September.  The broad S&P 500 index has also been trending downwards in the medium term, despite a long-term uptrend, due to austerity crisis concerns.  The bears certainly have control and both are hitting levels of resistance.  However, I believe they will breakout if and when a deal is reached in Washington.

On Dec. 19th, both the broader markets and AAPL were approaching levels of resistance.  Betting on the fact that we would not see a deal come out of Washington by week’s end, I bought 1000 AAPL 525 Puts expiring Dec. 21st priced at $3.75.  Subtracting commissions, the value of the puts I purchased was around $375,000.

AAPL 525 Put Opened 5/19

AAPL 525 Put Opened 5/19

On the morning of Friday, Dec. 21st, AAPL stock dropped to a low of $510.24.  Because of this underlying price drop, the price of the OTM AAPL 525 Puts I bought for $3.75 were now worth over $12.00, because they became ITM.  By 11:00 am on Dec. 21st, the value of the 1000 puts I was holding was worth over $1.2 million.  That’s a pretty good gain.  However, I didn’t sell the puts and chose to hold them through expiration.  AAPL rebounded off a major increasing trendline and closed the day at $520.17.  The puts decreased in value and expired at a price of $5.45 resulting in a total cash value of $545,000.

AAPL 525 Put Expired 12/21

AAPL 525 Put Expired 12/21

Eh, should have closed out my position earlier in the day.  But my overall options strategy is to initially look at the fundamentals of the macroeconomic environment and the specific company I’m trading.  This tells me what to trade.  I then look at the technicals to tell me when I should open and close my positions.

So I hope I’ve been able to explain options somewhat more clearly.  They are a powerful financial instrument to realize huge gains, but you must understand how to properly wield them.  Unlike normal stock, there is a real danger to lose your entire investment when you trade options.  When you’re holding normal shares of a stock and the price drops substantially, you could lose a large portion of your investment, and there’s always a chance the stock price could rebound so you’ll recover your loses, but rarely will you lose your entire investment, which can be common when trading options.

It should be noted that all transactions described on this blog were performed on the Investopedia Stock Simulator and not in the real stock market.  I have no actual positions in any stocks mentioned nor will I be initiating any actual positions in the next 6 months.  Furthermore, the information on this blog should not be considered financial advice.  The main purpose of the blog is to educate its readership, myself included, about concepts and ideas that were previously unknown to me.

  1. Alex
    January 16, 2013 at 12:41 pm

    Could you explain and perhaps give some examples of what you mean with: “Fundamentals teach you what to trade, technicals teach you when to trade”? I saw you mentioned it a 2nd time, and I was hoping you would show what you meant, but that did not happen.

    • Alex
      January 16, 2013 at 12:45 pm

      PS: I am more concerned with the “fundamental” part than then technical.

      • January 16, 2013 at 3:08 pm

        Ah, my apologies, I never did explain fundamentals very well. By fundamentals, I mean the underlying aspects of the business. Is generally it a good business or a bad business? Is the company growing and expanding or is their market share shrinking? What do the company’s financial statements look like, are they turning a profit or are their margins shrinking quarter over quarter?

        These are the types of questions I look at when I’m analyzing the fundamentals of a company. Fundamentals are the aspects of the business that make the business who they are and what they do, including the types of products they make, the industry they operate in, and who their competition is (also sometimes known as comparables, or just “comps”).

        Since it’s a company people simultaneously love and hate, let’s take AAPL for example. AAPL reported record earnings in January of 2011. Because their underlying business model was booming (that is, iphone 4 sales, tablet market share, earnings per share growth year over year), you could say that fundamentally they looked like a very good company. The stock consequently shot up and reached all time highs.

        Now recently it’s been reported that Samsung has sold 100 million Galaxy S units. Clearly, Apple is losing some smart phone market share, and, combined with a bleak product rollout outlook, their fundamentals moving forward don’t look so great. As such, the stock has absolutely tumbled reaching an 11-month low on Jan 15th, 2012.

        When deciding to invest in a company, it’s always important to consider the underlying aspects of the company. This is what I mean by “fundamentals teach you what to trade”. If you think company XYZ has a good business model, strong management, and opportunity for growth, then it’s an excellent company to invest in. But let the technical indicators (of both the macro-economic environment and the specific company) tell you when you should initiate your position in the company.

        I hope I was able to answer your question. In the near future, I am planning on a blog post that elaborates what I look for in a company when I’m thinking about investing in it.

  2. Anonymous
    February 8, 2013 at 8:06 am

    thanks for this, I’m new to investopedia simulator and i found this blog entry on the options very helpful. Becuase its for fun and not for real money I will be opening some options trades on my account soon to help me learn. Thanks.

    • February 11, 2013 at 2:00 pm

      You’re welcome! I was overwhelmed with the info about options on the investopedia simulator, so I thought it would be a good idea to explain things more clearly here. Good luck on your trades!

  3. Daniel
    March 3, 2013 at 11:03 am

    Thanks for this. I’m interested to learn more about the various options strategies. I understand the basic concept. I think some sort of mathematical equation to show the relationships between the greeks would help me to understand options better.

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