Seeking Alpha

Stock Option Trading Basics

by: William Sabin
Summary

The essential rules of stock option trading are discussed.

How to know your max gain and loss on every trade.

Example: How to trade earnings season.

options, trading, earnings, risk

Options - The Basics

Mention the idea of trading options to most investors and you will get comments like ‘those are too risky’ or ‘its gambling’ or ‘I just don’t understand them’. While there are option trades that are very risky (e.g. uncovered index options) which can feel like gambling, there are a number of strategies that an individual can use to have options as part of their portfolio. Below I cover some of the basics.

In almost every option trade, I like to calculate my maximum gain and maximum loss. Every prudent investor should know these limits before entering into an option trade. In general, most of my option trades are not designed to hit a home run and get rich. Rather, I tend to trade options for smaller gains with limited risk.

Let's walk through the basics of stock options.

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying stock at a specific price on or before a certain date.

The two types of options are calls and puts. A 'call' gives the holder the right to buy an asset at a certain price within a specific period of time. Owning a call is similar to being long (bullish) a stock. While a 'put' gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are similar to being short (bearish) a stock.

Every stock option trade is based on the use of a call, a put, or combination of both.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

For call options, an option is ‘in-the-money’ if the share price is above the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.

The cost (the price paid) of an option is called the premium.

One stock option is equal to 100 shares of stock. If you own ten stock options, you control 1,000 shares of stock.

Simple?

There is a lot more to know and that is where the risk comes in. Fortunately, the following items are most likely calculated and presented by your broker, but for a peek under the hood, keep reading.

One might ask how the premium is determined. This is where the complexity begins using things called ‘Greeks’ – delta, gamma, theta, and vega. The premium is determined by a number of factors including the stock price and strike price – the difference between these is called the intrinsic value. Delta and gamma enter into the equation here. In overly simplistic terms, the premium is the value that an option would have if it were exercised today.

Other factors include the time value remaining until expiration (theta) and the sensitivity of the price of an option to changes in volatility (vega). Theta is a measure of the time decay of an option – how much value an option loses each day due to the passage of time. I find theta and vega very useful in my trading.

If you want to get complex and see what goes into fair valuing a premium, read about the Black Scholes Model.
https://static.seekingalpha.com/uploads/2018/4/9/48350476-1523287442027804.png

Thankfully, you can look up almost any option chain and the value (or at least what an option is trading for) is presented to you without having to worry about calculating it.

A Simple Example

One of the simplest option trades is the covered call. That is where you own a stock and you decide to sell a call option to someone else based on the rules above - remember a call gives the holder the right to buy an asset at a certain price within a specific period of time. Owning a call is similar to being long (bullish) a stock.

For example, lets say you own 1,000 shares of XYZ stock that pays a 2% dividend. Its currently trading at 50 and the May 11 55 calls are trading at $1.20. You decide to sell 10 calls to someone for $1.20. They have a month to exercise this option at 55. They pay you $1.20 for that right. Their break even is $56.20.

From your side, the stock is at 50 and your basis is 40. You don't think that the stock will get to 55 by May 11, a 10% increase. If you are right and the stock stays under 55, the stock option buyer will not exercise the right to buy your stock and you get to keep the $1.20 (this is like getting an extra dividend on your stock that you continue to own). However, if the stock goes to say 60, you have to sell your stock at the agreed upon price of 55. You gain then is limited to the 55 plus the premium you received of $1.20 or $56.20. You missed out on the additional $3.80 move in the stock ($60-$56.20).

A Slightly More Complex Example

Earnings season can be an especially volatile time for stocks especially ones where it seems everyone has an opinion of where the stock is headed with large dissimilarities.

There are a couple of ways to play earnings season - buy the stock, short the stock or buy a combination of calls and/or puts depending if you are bearish or bullish.

As an example, let's assume a stock is trading for 306. Let's also assume that 2Q18 earnings for this company will be released on May 2. You generally want to give the options a little time after earnings before they expire. As such, we will be discussing the May 11 expiration-dated options.

If you are bullish on this stock and think its future near-term earnings will exceed market expectations, one might consider the following trade example. Let's assume you think the stock will go to 345 by May 11. As such, you could buy a May 11 310 call and sell a May 11 365 call. The cost, max gain, and break even are shown below.

Essentially, this trade would cost you $1,759, but you have the potential to make $3,741, a 113% return over the next month. You will start to make money when the stock is over its break even which is at $327.59 in this example (the lowest strike price of $310 plus the net amount paid for the trade of $17.59).

Alternatively, if you are bearish on this stocks earnings, a trade one might consider would be as follows. Let's assume you think the stock will drop to 250 by May 11. As such, you could buy a May 11 305 put and sell a May 11 245 put. The cost, max gain, and break even are also shown below.

This trade would cost you $1,720, but you have the potential to make $4,280, a 149% return over the next month. You will start to make money when the stock is under its break even which is at $287.80 in this example (the highest strike price of $305 less the net amount paid for the trade of $17.20)

Exiting an Options Trade

Having a exit strategy with anything is a good idea. Its essential in most stock option trades.

Sometimes, like in the simple example above, your strategy might be just to keep the option open until it expires worthless. However, what if you really want to continue to hold that stock? Assume the stock gets some good news and it shoots up to 54. You can either hold out and hope that it won't continue above 55 or buy the option back - essentially a 'buy to close' order. There are more complex strategies, but these are beyond the scope of this article. Therefore, you buy to close the trade. Even with the time decay (theta), let's assume the stock option you sold is now trading at $1.75. If you buy this back, you will have a loss of $0.55 ($1.75-$1.20).

In the more complex trade above, in either the bullish or bearish example, you most likely will want to close out each side of the trade at the same time prior to expiration. Ensure that you do an 'all or nothing trade' - you don't want a smooth and well thought out exit strategy to be mucked up leaving you with an uncovered long or short position.

Take Away

Stock options can be a way to gain some leverage in your trading while mitigating risk. What is shown above only scratches the surface of everything you can achieve with stock options. There are ways to trade the volatility to your advantage.

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This article is intended to provide educational information to readers and in no way constitutes investment advice. Investing in public securities is speculative and involves risk, including possible loss of principle. The reader of this article must determine whether or not any investments mentioned in this article are suitable for their portfolio, risk tolerance, and accepts responsibility for their decisions. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer or a recommendation to buy, sell, or dispose of any investment or to provide any investment advice or service. An opinion in this article can change at any time without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.