Great Stuff Special Edition: You’ve Got Options!
For the next three days, Great Stuff is forgoing its usual mission to suck the marrow out of the financial media’s headlines.
Why, you ask?
To teach you about options trading!
(And also because I’m attending a company retreat in sunny Orlando, Florida, this week.)
So, you want to trade options, but you don’t know where to start?
Well, you’re in luck! Great Stuff will give you a primer on trading options. Just remember: You asked for it! (Don’t worry … I’ll take it slow.)
So, Mr. Great Stuff, what’s an option?
Oh … we’re starting out there, are we? That’s OK! We’ll start with the basics.
An option is a contract that gives you the right (but not the obligation) to buy or sell a stock at a certain price. Like all contracts, an option contract has two sides: the side that writes (or sells) the contract and the side that buys the contract.
These contracts don’t last forever. They expire after a certain time, typically on monthly, weekly or yearly intervals. After all, you don’t want these things sitting out there until the end of time. You have a schedule to keep.
You still with me?
Yes, sir! Options contracts let you buy or sell stocks at a set price by a set day.
Good! Now, this is where it gets a bit complicated … but only a bit.
So, each option contract typically represents 100 shares of a stock. When you see an option for Tesla Inc. (Nasdaq: TSLA), that contract controls 100 shares of TSLA.
Here’s the thing: When you look for option prices, the price you’ll see is for each individual share in a contract. Yet, your option contract lets you control a whopping 100 shares! (Take that, stock investors.)
For the option prices you see online, multiply the price by 100 to arrive at the total cost of your contract.
For instance, let’s say you’re looking up TSLA options that expire in May. You see that a TSLA May $700 strike call option is priced at $90. (This is just an example price … your results will vary.)
Hold up … $700 strike? What are we hitting?
“Strike” is fancy options trading lingo for the price at which you want to buy or sell a stock. So, a $700 strike call option means you want to pay $700 for TSLA shares.
Now, you might think that you can buy that option contract for just $90 … nope. Remember to multiply that $90 by all 100 shares of TSLA that the contract represents.
As such, your TSLA May $700 call would actually cost you $9,000. That may seem steep, but it’s a lot cheaper than actually buying 100 shares of Tesla at $700 each. (Don’t worry, not all options are this expensive.)
This, class, is called leverage! Options allow you to take an interest in a stock with much less money than you would otherwise need to buy the shares outright. It’s the entire reason that people trade options to begin with.
I know that’s a lot to take in. But, if you’re still following along, you’re doing fine!
Calls and Puts: The Nuts and Bolts of Options Trading
I love getting more leverage in my trades … but what’s a “call”?
OK, so there are two basic types of options: calls and puts.
A call option is a contract that gives you the right (but not the obligation) to buy a stock at a certain price (or strike) in a certain time frame. That TSLA May $700 strike call I mentioned above? It lets you buy 100 shares of TSLA for $700 each before the contract expires in May.
Similarly, a put option is a contract that gives you the right (but not the obligation) to sell a stock at a certain price (or strike) in a certain time frame. Keeping the Tesla example, a TSLA May $700 put option would allow you to sell 100 shares of TSLA for $700 before the contract expires in May.
Why would you ever want to do a put? Well, if you’re holding the shares, you can only make money if the stock goes up. Why not make money when it inevitably goes down? Even the strongest, most bullish stocks in the world pull back eventually … and you may as well make money on it in the meantime.
But Mr. Great Stuff, what if I don’t want to buy 100 shares of Tesla? I can’t afford that!
What, you don’t have $70,000 just lying around to buy TSLA stock? Amateurs…
Don’t worry. Don’t worry.
While some people do use options to actually buy and sell shares, most traders cash in their options before they even expire! That’s right: You can use options to make money off the contracts themselves — without ever touching a share of the stock.
Remember, an option gives you the right, but not the obligation, to buy or sell the stock.
As a stock goes up and down in value, so does the value of options on that stock. Specifically, a call option climbs in value when the stock goes up, and falls in value when the stock goes down. (Vice versa with put options.)
To keep this simple, we won’t go into the complicated way that options are priced. Just know that there are three factors that determine an option’s price:
- Intrinsic value — The actual price of the option contract minus all other outside influences.
- Time value — The portion of an option’s price assigned to the amount of time left on the contract. Typically, the longer you have for a stock to make the move you want, the more you’ll pay for that window of safety.
- Implied volatility — This one can get weird. It’s essentially the market’s estimate of how much a stock will move in a given amount of time. Basically, the price is higher for stocks that move a lot, and lower for stocks that don’t move much at all.
That’s a lot of scary stuff right there … and I even kept the descriptions as simple as possible.
When you buy an option, you pay for three things: the option (intrinsic value), the time that option is open (time value) and how much the market thinks that stock will move (implied volatility). When your contract expires, its time value and implied volatility fall to zero — there’s no time left on the contract for the stock to keep moving.
The Shocking Truth About Options!
We’re going to make this even simpler. For now, let’s only look at intrinsic value in our Tesla example.
As it turned out, TSLA shares soared from $700 to $800 while you held your contract. Congrats!
When our TSLA May $700 call option expires, the intrinsic value of that option would be $100, or a full $10,000 for the entire contract. Remember, you multiply the price of the option by 100 to get the full value of the contract.
Since we paid a total of $9,000 for the contract, our profit would be $1,000. Easy peasy — you made a nice gain on the call contract.
But what if you originally thought TSLA stock would plummet? Let’s run through an example where you bought a put option instead of a call. Remember, puts gain value when a stock goes down.
Say we bought a TSLA May $700 put option for $90. Again, that tallies up to $9,000 per contract. It turns out that you made the right decision once again — look at you, already a pro! — and TSLA stock crashed while you held your put option.
Tesla stock ends up trading at $600 when your put option expires. That option’s intrinsic value would be $100, or $10,000 for the full contract. Our profit again would be $10, or a grand total of $1,000 for the contract.
Clear as mud, right?
What happens if TSLA is below $700 when the call option, what did you call it … expires?
Good question. Even with all the expertise and foresight in the world, not every trade goes our way. But oftentimes, taking a loss in an option trade won’t sting as much as if you held the stock.
That said, remember our golden rule with options! Like all investing, never invest more than you’re OK with losing.
In our TSLA May $700 call example, if Tesla shares are below $700 when our contract expires in May … we get nothing. Nada. Zip. It’s a 100% loss. The same is true for the TSLA May $700 put option. If Tesla is above $700 when this May put contract expires, we get a big ol’ zero.
The great thing is that your initial investment is all you can lose when buying an option. (That’s a great thing?!) Remember that options are a leverage game, letting you control more shares for a fraction of the cost.
Let’s Get Leveraged
Let’s put that 100% loss in perspective.
You paid $9,000 for your TSLA call option, right? That let you control 100 shares. To buy those same 100 shares, it would’ve cost you $70,000. With $9,000, you can only afford 12 shares at $700 each.
If TSLA falls to $600, your option is a complete loss. $9,000 down the drain. If you owned 12 shares, you’re out only $1,200 … if you manage to sell at $600. But that’s with only 12 shares. If you owned all 100, your loss is $10,000. That’s more than what you paid for the option.
Meanwhile, if TSLA rallies to $800, you only made $1,200 on those 12 shares.
But that TSLA $700 call option? It’s worth $10,000 — the same as if you’d owned all 100 shares — and yet, you only paid $9,000 and not $70,000 to get the same return.
That’s what leverage really means: It lets you keep a smaller chunk of your portfolio invested in any one trade … for even more profit potential!
So, let’s recap today’s data dump on options:
- Options are contracts to buy or sell a stock at a certain price in a certain time frame.
- A contract’s “strike price” is the price at which you want to buy or sell the stock.
- Options contracts represent 100 shares of a stock.
- To get an option’s actual price, you multiply the price by 100.
- Buying a call option is a bet that a stock will rise.
- Buying a put option is a bet that a stock will fall.
Sheeew … so, that’s day 1. Book it. Done.
Now, I bet you’re just itching to get into the options market! That’s where I have to tap in my colleagues Ian Dyer and Paul , whose Rebound Profit Trader research service uses calls (and sometimes puts!) to great effect.
With this dynamic duo, you’ll have two standout guides to the options market — your leg up on this lovely land of leverage.
If you have any questions, feel free to send them to us at GreatStuffToday@banyanhill.com, and we’ll see what we can do!
Until next time, good trading!
Editor, Great Stuff