My latest guilty pleasure in the world of the stock market is options. They are generally considered (and often subsequently dismissed) as being too risky for most investors. A better way to describe it is that they have a different risk/reward structure than traditional stocks.
A call option gives you the right, but not the obligation, to buy a stock at a certain price within a certain timeframe. A put option gives you the right, but not the obligation, to sell a stock at a certain price within a certain timeframe. That certain price is called the strike price and the timeframe ends at the expiration date, which is the third Friday of the month for which you bought the call. Each option you buy is called a contract and controls 100 shares of the underlying stock. For example, 1 contract of Home Depot AUG $40 calls would give me the right to buy 100 shares of HD for $40 per share anytime before the end of trading on the third Friday of August.
Why would I want a call? Well, calls are comparatively inexpensive. The HD $40 AUG call might cost me $100. Prices are quoted for a single share, so the call would be listed at $1, which would cost me $100 since the contract is for 100 shares. Let’s assume that Home Depot was trading around $35 when I bought the call. If HD stock starts going up, so will the value of my call. You might think that the price would have to go above $41 before the expiration date to make any money. That would be true if you planned to hold your calls until expiration. The other possibility is that you sell your call before expiration. Let’s say that Home Depot stock goes up to $37 within a few days of buying the call. That’s a 5.7% gain for the stock. The option might also go up by $2. In that case the option has gone from $1 to $3, which is a 200% gain.
One way options make you money is that for a smaller initial investment, you can control a larger amount of stock. Instead of spending $3500 for 100 shares of HD, you can buy the right to the gains on the stock above $40 for only $100. Of course the downside is that if the stock is trading at less than $40 when the option expires, you lose all the money that you spent on the option. Remember, though, that you could always sell your call before expiration to limit your loss.
Why would I want a put? Let’s say there’s a stock that I think is going to tank. If I own the stock, I would probably sell it. But if I don’t own the stock, I can still profit from it going down. One way to do that is to sell it short and then buy it back at a lower price. But to me, short selling is really risky, because if the stock takes off I could be out a lot of money. So an alternative to selling the stock short would be to buy a put. If the stock was lower than the strike price at expiration, I could buy the stock at the low market price and then exercise my put to sell it at the higher strike price. Of course the alternative would be to just sell my option before expiration so that I would not have to get involved with the actual stock.
My strategy for options:
I’ve seen many of my stocks dip down to about 90% of my purchase price while I’ve held them. So in a sense, I’m OK with, and somewhat tolerant of, a 10% loss in my stocks. So instead of spending all of the money I had allocated for a particular stock, I might only spend 10% of that and use it to buy options. The worst case scenario there is that the options expire worthless and I lose all of my money. But remember, I’ve only spent 10% of what I was planning on spending, so losing all of my money is really only losing 10%. The best case scenario is that the underlying stock takes off and I make a large gain on my options. I have been buying options to sell them within a few days or weeks, as opposed to holding them until expiration. So I’m looking for small moves in a stock to let me cash in faster through the use of options.
Here’s an example of my first option trade:
The S&P Mid-Cap Spider (MDY) was had been down for a few days in a row. It was trading around $132. I bought two MDY $135 calls at $2.80 which were set to expire in about 40 days. Within two days, MDY peaked at $136 and I sold my options for $3.50. So in the course of three days I took $560 and turned it into $700. That’s a 25% gain in three days. I had set up a limit order to sell my calls at $3.50 and I’m glad I did. That day, only 10 options exchanged hands at that price and mine were among them. The window of opportunity to sell at that price was only about 5 seconds, so my limit orders really paid off. I knew what limit price I wanted because I had calculated what sell price I would need in order to get the gain I wanted, even considering commisions and taxes. If, instead of buying options, I used my $560 to buy MDY, I would have been able to buy 4 shares of MDY for $528. If I had sold them three days later, I would have gotten $544 for them. So instead of making $16 (hardly enough to cover commissions), by using the leverage of options, I made $140.
There are many more advanced strategies using options than the ones I’ve described here. There is a lot of good information available through websites and books on the subject. As long as my way of doing it keeps making me money, that’s the way I’m going to continue doing it.
No comments:
Post a Comment