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?
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.
I also document some of my trades and learnings
On a monthly basis, I report the progress of my play money.
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.