“Leverage!” say the options traders. “It’s all about leverage! With one option contract, you control one hundred shares of stock!” The word “leverage” is a form of “lever” and reminds me of a crowbar. Hit an assailant with a crowbar, you could do some damage. However, if that person grabs the end of the crowbar and turns it against you, you would have been better off in a fistfight. Spectacular profits are what you get when the leverage from an options position works in your favor. Spectacular losses are what you get when a miscalculation puts you on the wrong end of the lever.
I love options. I haven’t been trading long, but as I learn the ropes I can see potential. I believe there is a living to be made that way, but there are no “get rich quick” methods that work. Success in trading takes patience, education, and enough capital to roll (often literally) with the punches. Here are some things to consider before diving in to the options market.
1. Buying power.
When you sell a naked put (for example), you will see a credit to your account. In essence, you have sold “stock insurance”. In the simplest situation to consider, the buyer of the put is afraid her stock will decrease in value. She buys the right to sell you the stock at a certain price so that even if her stock plummets, she won’t have to sell for under a certain price (the strike price of the put).
Even though your cash balance has increased, your buying power will decrease. Why? Because your broker wants to make sure you can hold up your end of the bargain. If the strike price of the put is, say, 20, and the stock plummets to 10, you will have to purchase one hundred shares of that stock at 20! If you then sell them immediately at 10, you will have taken a loss, and if you hold onto them in the hope that the stock increases, you’re money is tied up.
Buying power makes it hard to diversify. You can’t just sell many naked options and hope the law of large numbers works in your favor. If you choose to sell naked, you will be very limited in the number of positions you can open.
2. Time value.
Buying options as a speculation is a potentially profitable endeavor, but beware time decay! On option contract for, say, three months in the future will be very expensive even if it is far out of the money. If, say, AMGN is sitting at around 47, no one wants to buy a 50 call that expires in two days. The underlying will, in all likelihood, not go up two dollars per share in two days. On the other hand, in three months, who knows what AMGN will do? They could get bad news from the FDA and go bankrupt. They could find the cure for cancer and shoot through the roof. Buying a 50 call doesn’t seem like such a bad deal. That’s why the price gets driven up. You would pay $200 plus commissions for that call.
If AMGN stays under 50 and doesn’t fluctuate much, your call will get more and more worthless as time goes on and it becomes increasingly clear that the underlying is stuck in a rut. Only if the stock price of the volatility increases dramatically will you be able to sell that call at a profit, let alone exercise it.
3. Hedges.
Very few people believe it’s possible to be sane and sell naked options. If you sold, for example, a 600 call on GOOG and it soared to 700, you could have to buy the underlying at $700 dollars a share and sell it at $600. That’s a difference of $100 per share for 100 shares. One contract cost you $10000. Maybe you sold the call for $4400, so you only lose $5600, but still, that’s rough. What if the underlying had gone to 800? 1000? The loss is literally unlimited.
Most options traders sell “spreads”. The simplest spread is a vertical. You sell a valuable option and buy a less valuable one to limit your loss. In this example, you would want to sell the 600 call while buying a 610 call. Your loss is then limited to $1000.
You will have smaller credits when you trade hedged positions. However, if you sell naked options, one wrong move could wipe you out. Don’t do it.
4. Rolls.
If it looks like the vertical you sold won’t work in your favor this month, you can do what’s called a vertical roll, buying back this month’s position and simultaneously selling next months. Rolls are a good way to stay in the game, but can get costly and use lots of buying power. Depending on the situation, a vertical roll can be a credit or a debit, and can use a lot of buying power or none at all.
5. Realize you have only scratched the surface.
I could talk all day about options spreads. Heck, I could talk all week about options spreads. There are iron condors, condors, butterflies, diagonals, straddles, strangles, diagonals the list goes on.
Some people have web pages where they promise that if you pay them they will teach you how to use a particular spread to easily make a lot of money. Don’t buy it, literally or figuratively. The key is having the right spread at the right time on the right underlying.
The more you know about options, the more tools you have in your trading toolbox. Never get so stuck on one type of trade that you close your mind to other possibilities. It’s fine to have a favorite strategy, but don’t pass up an opportunity or make a bad trade just because you “always do iron condors” or “swear by calendars”.