Trading with options is a fascinating topic.

And there is a lot to learn. It’s complex but it provides the experienced trader with an incredible amount of ways to trade.

Here is the official (but not so helpful) definition of an option:

“An option is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).”

Confused?

 

 

That’s OK! Definitions are for lazy people anyway 🙂

Let’s use an example.

Below is a stock chart that shows historic stock data over 5 months. What will the price be in the future? Should you buy this stock?

 

It could be a trend

There is no right answer, but we can work with an assumption: “Trends tend to continue”. So what is the current trend of this stock?

We can draw a line through the data and see how it looks.

 

 

Based on a linear trend line that has been drawn through the stock price data, it appears as if there is an up trend. And on average, the possible future price of this stock could be $246 within one month.

Now what you could do is to buy 100 stocks at the current price of $234, wait one month and sell them if the price reached the target of $246.

If you would buy 100 stocks, you would need to spend $23,400 plus commission fees. If you sell later at the target price, you would get $24,600 from this trade, gaining $1,200 (minus commission fees).

That’s not bad… but…

 

But I don’t have that much money!

But what if you have only $1,000 available on your account at the moment?

How many stocks can you buy?

 

 

You can only buy 4 stocks. And once you sell them, your gain would be 4 x $12 = $48… minus commission fees. Meh…

But there is another option (pun intended!).

 

Call Options

 

 

You could buy Call Options.

These options give you the right (but not the obligation) to purchase a stock at a specific price. This price is called the Strike Price of the option.

 

 

Let’s say that there is a call option available with a strike price of $235 and a validity of 1 month. It costs $2 per option.

What would be your gain if you purchase 500 call options (as you have $1,000 available to spend)?

 

Options create leverage

 

 

The calculation goes like this:

Gain = Stock Target Price minus Strike Price minus Option Price, and then multiplied by the number of options.

In our case, with numbers: ($246 – $235 – $2) x 500 = $9 x 500 = $4,500

Now that’s a big difference to the previous meager $48! That’s 93 times the amount! By using the same amount of money!

That’s why trading options are often related to leveraging. Pretty cool, huh?

 

Put Options

What if you believe that the market will go down instead of up? Can you make money by buying options, too?

YES, you can!

Instead of buying Call Options, you buy Put Options.

Put Options give you the right, but not the obligation, to sell stocks at a specific price (the Strike Price).

It works the same way like before. For brevity reasons, I did not repeat the previous steps, but if you like to review and compare them, get them from my Options Basics Guide (PDF file). The PDF file will be sent directly to your inbox.

 

It gets even better with option combinations

Imagine you anticipate a strong price move with high probability…

The drawback? You don’t know in which direction it will move (your research indicates it’s 50-50 each way)…

Not a problem with options!

Buy an equal amount of Call and Put Options. This will approximately double your costs (you buy options for each possible market direction), but as long as the price move is strong enough you can get a winning trade.

 

 

How does it compare to buying only Call Options?

Simply put, it improves your odds to get a winning trade, but it reduces your gains.

If the market moves up as before, you will gain only from the upwards price move, but you must bear the costs for all options. And if the market moves downwards, it’s the same vice versa.

Instead of gaining $4,500, in this case, you will gain only $1,750. Mind you, that is still good compared to $48…

Want to know more about it? Get my Options Basics Guide (PDF file) for more details.

 

So why bother with stocks if options are so great??

Granted, you can make spectacular trades with options with only a fraction of the money needed compared with stocks.

But there are good reasons why options are considered speculative and high risk.

Here are the most common ones:

• No free historical data
• Liquidity issues
• Fees
• Time limits
• Option Pricing

Historic data

Getting historical data for stocks is easy. Just check Yahoo and Google!

But historical options data is more difficult. Current data is also available for free, but historical data usually comes at a cost.

The reason is that it’s a lot of data. For each stock, there can be hundreds of different options (there are Put and Call options, and then there are many different strike prices and validity times).

Building useful models for trading requires data, lots of data.

And for options that data is more expensive to come by, and it is a lot more data, too. Creating your own models is harder, much harder than for stocks.

 

Liquidity

Because there are a lot more variations of options (many per single stock), the option trading volumes are lower than for stocks.

That means that sometimes you simply cannot buy the option that you like. Or you cannot buy it at the price that you think is fair.

And if you are into selling options… same issues, or worse. As I said in an earlier post, dealing with liquidity issues is difficult and managing risks is just so much harder.

 

Fees

Like any trade, there are trading fees.

But for options, these are usually higher. And if you want to exercise an option, there can be additional costs. So expect higher trading costs with options than for stocks.

 

Time limits

Options have a time limit.

At some point, they expire and become worthless if not exercised. You can buy options that are valid for less than a week – they are cheaper.

Or you can buy options that are valid for a year – but they come with a much higher price tag.

So be aware that options have a “time decay” built in. Their value decreases over time until they finally expire.

Options that were not used (i.e. exercised) will sooner or later expire and become worthless. In our earlier example with Call options, if the upwards price move would not happen, the invested $1,000 will become ZERO.

That’s not the case with stocks (unless the company suddenly goes bankrupt).

 

Option pricing

Determining what is a “fair” price for an option is very tricky.

So tricky that the people who built the nowadays commonly used option model did receive the Nobel Prize in Economics for their efforts. And yet, seasoned options traders understand that this model has flaws that need constant adjustment.

Options trading in a volatile market seems like a great idea – you can benefit from price jumps, independent of price direction.

But option sellers know all about that… so when they see an increase in volatility, they increase option prices (and vice versa).

That makes it very difficult for novice investors to benefit from trading options.

 

But there is a different reason for buying options…

What else are options good for? To reduce trading risks. How does that work?

You can buy Put Options (that give you the right to sell a stock at a specific price) to protect your stocks from down trends or market crashes.

Let’s illustrate this concept with an example:

 

 

You purchased stocks at a price of $234.

If the stock price drops rapidly and you do not sell early enough, you will experience serious losses.

You can limit losses by buying Put Options at a Strike price that is in the range of what you accept as a potential loss.

If you are OK with a possible loss of $9 per stock, buy Put Options at a Strike price of $225.

Even if the stock loses half of its value, as long as you have these options in place, you can sell your stocks at the strike price. Just do it before they expire! And you need to take into account the cost of purchasing the options.

This is an interesting way of reducing risk. In fact, it is the same thing as buying insurance. I will discuss much more about risk reduction in later posts.

 

So for now…

While option trading has great potential, it’s also very complex.

For novice investors, I recommend to start with stock trading before considering options – experience with stocks helps a lot. And you can use the same broker, so you are already familiar with the software and the fees.

Get my Option Basics guide to your inbox for more details (3 case studies included) about how to trade Call and Put options, as well as option combinations.

JOIN OUR FREE NEWSLETTER

Get the latest trading techniques right into your inbox.