There are many ways to trade options or use options in trading. Many people trade options for the sole reason that they are much cheaper than trading stock.
It is kind of interesting that it is rare to find an options trader that would ever buy a stock, or a stock trader that would ever buy an option. I believe that both camps are wrong.
You need to be able to trade both, or at least take advantage of both. The reason for this is that if you trade stock, you can minimize risk and maximize gain using options.
If you trade options, you do not get the full benefit of the stock’s move if you are right, and you “run the risk” of being assigned the stock, which scares option traders, and it shouldn’t. I’m not going to get into the fundamentals of options, but let’s digress for a paragraph or two to get some understanding before we talk about the strategy I want you to learn.
Buying is the opposite of selling. Long is the opposite of short. Bull is the opposite of bear.
There are only two things that matter in options; if buying an option, it must go beyond strike (in the money) for you to be paid on expiration day, and if selling an option short, you can end up long or short the underlying stock at the strike price.
If you keep these two things in perspective, your option trading will go a little smoother.
If you buy a call option, you are buying a right, not an obligation, to purchase a stock at a specific price (the strike price) on or before a specified date.
When buying a call option, you want the stock to go higher. If you buy a put option, you are buying the right, not the obligation, to sell a stock at a specified price on or before a specified date. When buying a put option, you want the stock to move lower.
Now the opposite side. If you sell a call option (going short the option) then you are selling the right to buy to another party, and if they exercise their right to buy, you must sell to them (you are taking on an obligation) and you could end up short the stock unless you already own at least 100 shares of it.
Selling a call option when you do not own the stock is called a naked call, but if you own the stock it is a covered call. If you sell a put option, then you are selling the right to sell to another party, and if they exercise their right to sell, you must buy from then.
If you are short the stock, you will buy it back (this is a covered put), but if you are not short the stock, then you could end up long the stock.
Now that we have that out of the way, let’s use these concepts to try and make a little money. Let’s make the assumption that we want to buy a stock. Let’s pick an expensive stock to prove a point and then we will look at a “normal priced” stock.
Everyone has heard of Amazon, so we will start with it. Below is a daily chart of Amazon (AMZN). You can see back in January when their earnings came out. Notice since then that Amazon moves up to the 860 area and then back down to the 840 area.
So let’s say we want to buy AMZN when it gets back down to 840. Now we can put a buy limit in, good till canceled,and wait for AMZN to sell back off and exercise our limit order.
Then when it gets back up to 860, sell it and make $2000 for every 100 shares we buy. If we buy the stock, we will need to put a protective stop below 830 (notice that is when earnings came out), so we will risk about $1000 to make $2000. Nice trade, pat yourself on the back.
Now let’s do it using options.
Daily AMZN Chart
Same trade with a twist. Instead of putting in a buy limit, let’s sell a 840 naked put option.
Now this does two things; a) if AMZN gets to 840 or lower at expiration, you will end up long the stock (that is what is desired in this case), and b) by selling a put option, you will bring in money. In other words, the market is going to pay you to place a buy limit on a stock (that is pretty cool).
Below is an option chain for AMZN. Based off the chart, AMZN is trading at 848.96, so AMZN is going to have to drop 9 points to exercise us. So it would probably be good to wait a while before selling the put to get more premium, but since we cannot put extended time in an article, we will use what we have (the concept is the same).
Look at the Mar 31 ’17 options. The 840 put is selling for around 4.10 (Last Trade). So if we put an order to sell at 4.10 and are filled, we will bring in $410 of credit. If by Mar 31, AMZN does not get to 840, we keep the $410 just for trying.
Note: if AMZN drops to 848 from 840, the put option will increase in value and your account will show that you are losing money on the option. This is not the case unless you buy it back at a loss.
Remember the end game, you want to be long the stock from 840. AMZN will have to be below 835.90 for you to start to lose money (840 – 4.10 (premium brought in from the sold put) = 835.90). Let them exercise if they can, that is what we want.
If we get exercised, then we will put a stop below 830, around 829.89 (just below 830 by a little bit), Risking $1,011. We will then sell a 860 covered call and probably get another 4.00 or so.
So total premium brought in will be $810. If AMZN drops and stops us out, we will need to buy back the covered call (that now has turned into a naked call), but since AMZN has dropped, the call will decrease in value and we will probably be able to buy it back around 1.00 or so.
So we get $700 in premium and lose $1,011 on the stock for a total of $311 loss. Now, if AMZN goes up, and we get called away at 860, we get $2000 off the stock and $810 off the options for a total of $2810. So in this case, we are risking $311 to make $2810.
Which scenario do you like best, a 1:2 risk/reward or a 1:9 risk reward? This is the luxury of options.
AMZN Option Chain
AMZN is a bit extreme since it is an expensive stock and is quite volatile. Let’s go to the blue chips and grab a stock like Caterpillar (CAT). Below is a daily chart of CAT.
Notice it has support around 92 and resistance around 95. Next support is around 90.50, so we will use 90.19 for a stop if we get filled. Using the same technique let’s look at selling the 92 put. In the option chain below, the 92 put is going for around 0.80.
Again, if it does not get there we get to keep the $80 and try again. If we get exercised, we place the protective stop at 90.19 and sell a Apr covered call at 95 for around 1.21.
There are weekly options on CAT, however, we want to be able to finance the protective stop the best we can. By going out to the monthly option, we can get there.
If we add the two options together (0 .80+1.21=2.01) we will bring in about 2.00. If we are long from 92 and need to risk to 90.19, we risk 1.81 on the stock.
The premium we bring in will cover the protective stop. If we get stopped out, we buy back the short call and will probably lose around $25 or so depending on how much time is left in the option. If CAT moves up and we get called away at 95, we pick up $300 from the stock and $221 from the option premium for a total of $521.
Again we can have the standard 1:2 ratio, but the 1:20 ratio of this trade seems much better.
Daily CAT Chart
Written by Tom Busby
This article is supplied courtesy of WealthPress.com.
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