Trading options

As part of my 2015 goals, I started an options experiment in order to learn, understand and practice the basics of stock options trading. Curiosity is at the basis of this experiment. Are options really that dangerous due to the leverage? Is it gambling like playing the lottery?

This page is a collection of all my learning and experiences around option trading. I will help me to formalize all my learnings so I can revisit at times of doubt

As with any new topic, there is a certain learning curve to go through. I first made some mistakes. I now start to understand how options work (I am not an expert, but not a rookie either). I have now a goal on how much I want to earn on trading options. I report my progress on a regular basis in the play money reports.

I will jump straight into my learnings. The basic theory of options is explained at the end of this article, just a little scroll away.

Why not sell options?

IMG_4928_29_30

The buyer of an option pays a premium and needs to be right on the timing and direction. If he is wrong, he looses the premium.

The fact that an option looses value over time, if all else is equal, is called time decay. An example. An out-of-the-money option worth today 1 (based upon volatility, underlying,…) will be worth 0 at the strike, if nothing changes. It is this time decay that makes selling options interesting. Selling options has its own risks and issues.

 

 

After reading a lot on options, and buying myself once an option, the conclusion is clear: Selling options is the way to go for me. (Do your own research, I am curious to see what your conclusion is). Here are my reasons to sell options.

Why sell a put

How to manage a put

What I learned from a put almost going wrong

Why sell a covered call?

How to manage a call

What I learned from call going wrong

The need to balance puts and calls

I also document some of my trades and learnings

GDX runs away

XLY dances

the full series of trade analysis

On a monthly basis, I report the progress of my play money.

 

The theory

There are puts and calls.

A call gives the owner of the call owner the right (not the obligation) to buy the underlying at a given price (strike) before a given date (maturity date). In exchange, the owner of the call pays a premium to the seller.

A put gives the owner of the put the right (not the obligation) to sell the underlying at a given price (strike) before a given date (maturity date). In exchange, the owner of the put pays a premium to the seller.

As you can see, there is only a small difference between the 2… but is an important difference.

The price to be paid for the option depends on a lot of variables, the most important ones are the current price of the underlying, the time till the maturity date and the volatility of the underlying. The last one is harder to understand, in short: how much does the underlying moves in price over a given period. Is it a rollercoaster, then the volatility will be high, is it a smooth ride, then the volatility will below (There are more elements to it, like the fear that there is in the markets.)

One key element of options: at the expiration date they are either worth 0 or the difference between the price of the underlying and the strike price.

A small detail: options are traded in multiple of 100 underlyings (there are exceptions) but the price is listed for 1 underlying. So, if an options is quoted 50 cents, you actually have to pay in total 50 for it (plus trading fees)

Why buy a call option?

If you think that the underlying will go up, then you can buy a call option. With a limited investment – the premium – you could get great returns. Imagine stock ABC, worth now 50. You buy an option that expires one month from now at a strike of 55. You pay 1 for this.

If at the end of the month the stock is worth 60, then you just turned your 1 into 5 (you can buy it at 55 and sell to the market at 60: a profit of 5). You just multiplied your investment  5 times.

Sounds easy? here is the caveat. The stock needs to be above 55 by the end of the month. If not, the options is worth 0 to you. Imagine the stock is at 54,5 by the end of the month and the jumps to 60 a week later. You lost your premium.

Why buy a put?

You own the underlying and are afraid it will loose value due to a market correction. You can buy a put on the stock with a strike that still gives you a profit. If the market drops in your timeframe, you can sell it at the agreed price and lock in a profit. This will cost you the premium to do so. If the stock does not drop, you loose the premium.

This overview is published to keep track of my own progress. It is not intended as investment advice for the readers of this blog. Before making a trade, you need to do your own research and you need to understand the risk of the trade.

 

 

 

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23 thoughts on “Trading options

  1. I’m still learning about the option trading, your post helps clear things up a lot.

    but I’m pretty bad at predicting stocks, as for now, I’m happy to just standing on the sideline of option trading,and stick to the traditional. Let’s the pro like yourself do the work. 🙂

    Thanks for sharing.

    Like

    1. Happy to read that the posts help people.
      Calling me a pro…You make me blush! I consider myself a starting retail option trader? still a lot to learn. I try not to predict to much the future, I rather have time working for me.

      Liked by 1 person

  2. Thanks for the good read on options. I sell covered calls and cash secured puts. I’ve never bought an option yet. I’ve had good luck overall with my options strategy. I have a few calls that are active now. I sold them in January when markets were down. A few of those options could close in May with my losing a decent amount of money. Even if this happens, I’ll still be positive overall. Time will tell, maybe another dip will happen in May and I’ll get to keep my shares.

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    1. Would it be possible to roll your calls? I had the same with some of my calls: i would be called away when i did not want that to happen. I managed to roll.
      I have learned from that not to write a covered call unless i am really really really happy with the strike

      Liked by 1 person

          1. Ah yes. I’ve done this a bunch of times too. In one case, for my Copa Holdings, CPA stock the price has gone up almost $25 a share since i sold the call. It would cost me too much. I have until May 20th though. If the stock drops enough, I will do as you described.

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  3. very good summery! =D

    i bought some calls and puts unintentionally. it was a mistake, and I lost a little money. For me its all about selling options 🙂

    looking forward to your monthly option income. I think myself had a very good month 🙂

    Like

  4. Hi Amber Tree Leaves,

    What I find a nice tactic too is sell out of the money covered calls when the underlying stock is around 10-20% overvalued. That way you know it will drop significantly. You can do the same trick when a stock is undervalued and you sell a covered put. That way you take away the risk of the stock dropping or increasing more.

    Nice blog. Will be back for more!

    Regards,
    Asset Blogger

    Like

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