Options, a mythical product with leverage that can ruin you… Does that not makes you curious? I does makes me curious. What is this leverage they speak about? What are the margins you need? How can you loose more than you invest? Being naturally curious, I needed to find out. And so I set my first steps into option trading. Join me and learn from my mistakes. I will share with you my first 2 trades and what I have learned so far.I have no lack of theoretical knowledge of options. I know what a call is, what a put is. In theory, I know how to use them and hell, I even know what the Greeks mean and how the American one is different than the European one.
But it all is theoretical knowledge.
The first move
Somewhere at the year end of 2014, the markets took a serious hit on a day, it continued the next day. I was so sure that we were seeing a big correction. I wondered how I could make money out of this. Then, the solution came to my mind! buy a put on the AEX (Dutch exchange) index and earn a lot of money in the drop.
So, I bought the option, and the markets drop a little further. I was soo happy. But then, it stopped, the markets went up, and my options was now worth less that just a few hours before. By the end of the trading day, I had a paper loss of some 10 percent all ready. I felt bad, but I was too proud to take a loss, and I was too sure that the markets would drop the next day. But they did not, the went up, up, up…. Stubborn as I was, I kept the option a few days longer, a few days longer till it expired and I lost it all.
With hindsight, the seed of this bad trade was caused by this: short term greed and over confident in my experience.
What did I learn: If you use options to speculate on a share drop or rise,make sure you have stop loss in mind on when to cut the losses. And stick to it. I did not have this. Big mistake. Actually, it comes down to having a plan and running through all the possible scenarios before you enter the deal. In that case, you know how to react if A or B happens.
Nothing for a while
For a few months, I ignored options totally. It seemed to be too complex for me, required to much skills to deal with it. In stead, I focused on index investing, started to study that and implemented a 3 ETF asset allocation. By doing so, I came across the Personal finance blog sphere. To make a long story short, I have a blog now.
The new seed
In reading a lot of blogs, I started to read the blog of a passionate options trader. I also spoke to a colleague that is a fervent put writer. And I got more and more intrigued again. It got me fired up again. This time, I focused my attention to what trade to make as a options newbie. It turns out that writing a covered call is a good way to start.
What does this mean? You own a stock already and want to get some extra cash out of this stock, next to a dividend or price increase. To do so, you write (sell) a call. This means that you now have promised to the buyer of the option the following: before the expiration date, you will sell your stock to him for the strike price of the option. In return you get the option premium already now. You already own the stock, so it is called a covered call. Your obligation is covered. To make sure the options stays covered, your broker will block the shares into your account. You can look at them, you get the dividends, but you can not sell them.
Remember what I have learned from my first trade: have a plan in place for all scenario’s. So, here we go:
- The stock is quite stable and never goes above the strike price
at the expiration date, the options will expire out- of-the-money, meaning it is worth zero for the owner. And that is a good thing, because I am the seller, not the owner. I get to keep the premium paid. This now lowers the cost of the stocks
This scenario required no further thinking from me. All is good. No need to do anything.
- The stock starts to trade above the strike price
The owner of the options now has an in-the-money option and can call it. He can force me to sell the stocks to him, at the agreed strike price, even if I can sell them higher on the market place. This means that I now have an opportunity cost: I can not sell at a higher price than the strike.
I could also buy back the call option and sell the stock for more later. The option is now in-the-money (stock price is above the strike), so it will cost me at least the stock price – the strike price. The stock would need to rise further to get enough profit from this.
Other possibility: The strike has to be a price I am willing to sell at. My total price will be the stock price plus the premium you got when selling. Nothing more.
This scenario seems acceptable for me. I get to calculate the maximum profit I get out of the trade. And I get to choose the strike price myself, so I decide to pick one that gives me some 4/5pct return. Reasonable, right?!? Greed already made me loose money before, so lets avoid this.
- The stocks takes a heavy drop
If I wanted to sell, bad news, I can’t because they are blocked into my account, remember. I could buy back the call and then sell my stock. This would cost me money. But, it is very likely that the option is worth less than I paid, so I could make a profit on the option and hope not to loose to much on the stock.
Or, I could just sit and wait till expiration date, and start again and hope for recovery.
For me, this is actually the worst case scenario to happen with covered calls. This is the scenario that would make me sleep bad if it happened. How to solve this? After some thinking, it seemed best to do this trade with a stock that would fit my future dividend growth investing strategy (In the long run, I want a DGI portfolio). A price drop would not be disaster, especially if the original price is a fair price.
In fact, it is actually better to sell covered calls on stocks you already own for a while and that have made you already some profit. In that case, you have some more margin to move. As I don’t own individual stocks, this is not possible for me. And for my trackers, there are no options available
The new plan
To recap, I need to look for a stock that I want to own for the long run, that is a well known dividend payer, and one that is cheaply priced, even considered a bargain.
I looked around and discovered Royal Dutch Shell. It traded around 26 at that time.That seems to be a fair price, giving a dividend yield of nearly 6pct. This would be a stock to keep forever, it has this reputation. This seems to be the ideal stock to cover the third scenario: the stock drops well below the strike. I do not want to sell, I just keep it.
Next, I would need to figure out the maturity date and the strike price.
A strike of 27 seemed fair to me. That would mean a 3,5pct profit in 35 days, all costs included. Way better than my savings account where the money was parked. The real profit would be a little higher, I need to factor in the option premium. Still, it would be below my set target. But i am so eager to learn that I accept this.
On the maturity, I decided to go for the Jul 2015 maturity. The June maturity was only a few days away and the cost of the option trade was too close to the option premium. The premium for the Jul 201 was rather low, somewhere between 0,18 and 0,24 throughout a few days. But I decided to pull the trigger, now that I had a plan for each possible scenario.
Execution of the plan
I was able to buy RDSA all costs included for 26,095 and sold the call for 0,18, all costs included. This means I now own RDSA for 25,915. Looking at yield and the price that DGI bloggers are willing to pay for it, this seems a fair price to me. (If you plan to do the same, do your own research)
What happened next surprised me, especially on the emotions side. Despite having all scenarios covered, having a rational and well thought reaction ready, I experienced some weird emotions.
On Thursday, the stock started to flirt with the 27,00 price limit. This actually made me more nervous than I thought. I suddenly did not want to sell the stock anymore, It was mine, it was doing fine, I was not going to give it away. Weird, because the plan is in place, the case is covered. This is a valuable lesson for me. It seems that I am emotionally attached to the stocks that I own. I need to work on that.
One of the points that fueled this love for my stock was my behavior. I checked a few times per day what the stock was traded at. This must stop if I want to work with options. I do not want to be curious all day long, I do not want to have the need to see if all is ok. That is not investing for me.
The next 3 weeks
Over the next 3 weeks, I will try not to look multiple times per day to see what RDSA is traded at. I will just stick to the plan and try to learn as much as possible from this experiment to see if options is something for me.
I dumped the greed part, I now understand what strategies are good strategies to start with, I have considered all scenarios and am comfortable with that, at least, before making the trade.
Do you have any options experience? Do you have any advice for me?