To trade stock options successfully, you should have a strong foundation in basic stock market knowledge and an understanding of how options work. Options are contracts that give the buyer the right, but not the obligation, to buy or sell a specific stock at a predetermined price on or before a certain date.
Recently, I received an email from a registered student regarding stock options.
He asked me
“Do you have a system to help me make money in stock options?”
He had invested in training, but the course was mostly about following a specific stock options trading system.
My reply was:
I advise investing in your education so you can truly understand how to evaluate stocks and decide on a stock’s future direction. Also, before you use options, you need to be able to make money with regular stocks.
Options have risks; time is always against you, and you need to be able to judge the direction of the stock market and an individual stock.
1. Understand Options vs. Stock Trading
Stock options share some similarities with futures contracts and normal stocks but are inherently different. Options are simply a contract; you do not own the underlying stock. The stock price determines the value of your options contract. Unlike stocks, you can hold indefinitely, options contracts all have an expiration date, and the closer to the expiration date you get, the less your option is worth.
As you do not own the stock, only a promise to pay the difference between the stock price now and at some point in the future, you will see that the options contract costs as little as 2% to 20% of the cost of owning the stock.
Stock options are simply vehicles to achieve a goal. Options are a cheap and effective way to leverage your invested capital for those who cannot use leverage to increase their total investment pot.
The best way to understand options is to run through an example.
Buying Stocks vs. Options
For example. You have $1,000 to invest.
Strategy 1 – Buy the Stocks
You could buy five shares of Amazon Inc. (Ticker: AMZN) at $200 per share.
Total Costs: $1000
If Amazon increased by 10% over the next two months to $220.
Your profit would be ($220 – $200) = $20 per share. 5 Shares * $20 = $100
A 10% gain.
Strategy 2 – Buy Options on the Stock
You could buy one “At the Money Call Contract” for AMZN with a strike price of 200 and an expiry date of May 21, 2021. The contract value is $10 per share. Because you will control 100 shares with each contract and buy one contract, your costs for the trade are $1000.
In options speak:
- One contract means you will have control over 100 shares of AMZN
- At the money, the strike price of $200 per share equals the actual stock price.
- The Strike Price is the point at which the option will have a value (apart from the time value)
- The expiration date is when the option contract expires and loses all value.
In the same scenario, the stock price moves 10% to $220. The price difference is $20 per share. The contract was at a strike price of $200; therefore, $220 – $200 = $20 profit per share.
The theoretical profit would be 100 * $20 = $2000, which is a $2000 gain from a $1000 investment, or a 200% gain.
I say theoretically because the clock starts ticking on the time value when you buy an option. If the stock price took until the final month before expiry to move to $220, you would have lost all of the contract’s time value, which could reduce your profits. However, if the stock had moved 10% in a single day, you would have secured almost all of the 200% and kept much of the stock’s time value.
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Strategy 3 – Shorting a stock using options.
We are using the same scenario, but instead of expecting the stock to increase in value, we expect it to decrease.
AMZN has a stock price of $200
You could buy one “At the Money Put Contract” for AMZN with a strike price of 200 and an expiry date of May 21, 2025. The contract costs $10 per share, and there are 100 shares in a contract. The cost of investment is $1000.
In options speak:
- One contract means you will have control over 100 shares of AMZN
- “At the money” means the strike price of $200 per share has already been reached.
- The Strike Price is the point at which the option will have a value (apart from the time value)
- The expiration date is when the option contract expires and loses all value.
In this scenario, the stock loses 10% in value to $180. The price difference is now $20 per share. The contract was at a strike price of $200; therefore, $200 – $180 = $20 profit per share.
The theoretical profit would be 100 * $20 = $2000, which is a gain of 200%.
2. Read These Two Books on Options Trading
1. Getting Started In Options by Michael C. Thomsett
If you want to leverage your capital through options, do nothing until you read this book. It’s probably one of the best books on options for beginners.
Options are a difficult subject to learn, never mind to master; this will make getting used to the basics a walk in the park.
Options are a tough topic, and many new tools have been developed since this book was written. However, after reading this book, you will be equipped to begin trading Options. It achieves what it sets out to do.
2. The Bible of Options Strategies by Guy Cohen
This book takes you to the next level of understanding options.
You are taking away the mystery and helping you realize that options can be used to create regular income and as a fantastic vehicle for limiting risk and knowing your reward.
It has great strategies and is a thoroughly good read. As the cover says, this is the definitive guide to practical trading strategies.
Score 65%. Content: 4/5. Applicability: 3/5. Readability:3/5. Insight:5/5
3. Know the Risks of Options vs. Stocks
You can lose the entire investment if the stock price moves against you. However, this is quite rare with stocks; stocks rarely move to zero unless the company goes bankrupt.
If the stock price does not move in the period, your investment can also expire worthlessly.
The stock needs to move in the direction you place the bet to make a profit. If the stock price moves strongly, your profits can be quite large.
4. Understand Technical Analysis
Before trading a single stock options contract, you must understand Technical Analysis. Not only that, but you must also have a strategy that pays off. This means you must have already developed a profitable stock market strategy through which you make a profit.
If you cannot make money in stocks, you will lose all your money quickly with options.
Check out our Liberated Stock Trader PRO training for an in-depth understanding of technical analysis.
5. Time Counts Against You
All stock options contracts are time-limited. Before placing an Options Contract, you need to be sure that the stock will move in your direction before the contract expires. It would be best to find volatile stocks or at least stocks with a strong trend and increasing volume.
6. In the Money & Out of the Money Options
Understand the additional costs of buying an option in the money instead of out of the money. Buying an “in-the-money option” means the contract already has some intrinsic value. You will pay for this at the contract price. Alternatively, “out-of-the-money options” are cheaper, but they mean that the stock price has to move further before the strike price is hit and the option’s intrinsic value is improved.
7. Understand Calls & Puts
A Call Contract means you expect the stock price to increase and seek a profit relating to the increase. When you buy a PUT option, you expect the stock price to fall and, therefore, realize a profit based on the decrease. This is rather like shorting a stock. It would be best if you were sure of the direction of the stock.
8. Buying Calls & Puts
If you are new to stock options contracts, you must be a buyer of contracts. In this way, you limit your risk to the amount you have bet on the contract. Unless you have expert professional skills, you should only be a buyer of contracts.
9. Selling Calls and Puts – Don’t Do It
If you are the seller of an Options Contract, you have the benefit that time is on your side. Your goal is that the option expires worthless. Your reward is simply the value you get from the contract you have underwritten. However, Beware, as a seller of contracts, you are taking huge risks because you will need to pay out an almost unlimited amount if the stock skyrockets and you sell a Call Contract. If the stock price plummets and you sell a Put Contract, you will also have huge liabilities.
10. Don’t Get Too Complex
When you attend a seminar on stock options, they will fill your head with all sorts of complex strategies like Vertical Spreads, Straddles, Bull Spreads, Bear Spreads, and Box Spreads. If you make your trading complex, it will be a challenge to make money. Please keep it simple.
11. Liquidity & Open Interest Matters
Before buying any Options, check what the open interest is. This means trying to determine if the contract has a liquid market. Nothing is worse than buying an options contract and then being shocked that it is immediately almost worthless because no one is trading it and wants to buy it.
12. Be Ready for Profit & Loss Volatility
Be ready to see serious fluctuations in the profits or losses on an option. Sometimes, I see wild swings in potential returns. An option can show a 25% profit in a few minutes only to show a 20% loss a few hours later. An option is a leveraged investment that magnifies your gains and losses.
13. Understand Cash Allocation
Do not place your entire investment pot on any single Options Contract. Use only a small portion of your capital on options, and of that portion, do not invest more than 10% or 20% in any one contract. Remember, if your contracts expire worthlessly and you lose all your money, you have no more chips and must leave the table. You do not want that.
When dealing with options trading, the lot size is defined by the number of contracts available.
One standard stock option or equity option contract usually represents 100 shares of the underlying equity.
Lot sizes are crucial as they determine the investment size and risk involved in options trading.
Summary
Options are complex instruments, but the more you understand them, the more they make sense. With experience, you will see that they are an incredibly flexible investment tool. However, before considering trading options, you must understand how to pick stocks, evaluate the market direction, and formulate a strategic, systematic approach to investing.
Options are incredibly volatile and can quickly cause you to lose your entire investment. Options are a numbers game and should only be used by advanced traders who have received specialist training.
Options are great for magnifying your rewards, but you must be a successful stock trader before investing in Options. Learn how to make money in stocks before you use any leverage on your portfolio. Try the Liberated Stock Trader PRO Training before you research Trading Options.
Listen to Our Stock Options Podcast
Podcast 009 – Stock Options Trading Top 11 Tips
How Stock Options Trading Works. Included are my Top 11 Tips and Mistakes to avoid.
- Published: Sun, March 25, 2018, 23:00:00 GMT
- Duration: 00:09:54
That’s good to know that a stock option means you have a contract rather than owning the stock. My husband wants to start doing trading and investing, so I’m looking into different ways he can. We’ll have to see if he can be trained in this to better understand how this works and how to make a profit.