Ladies and Gentlemen, This Is an Option

Welcome to Options Bootcamp.

Each week in these pages, I’ll give you the options basics you’ll need to become a True Options Master.

Think of it like training camp for football, and picture me channeling my inner Vince Lombardi as you learn.

With that, I probably have your attention now.

Let’s dive in…

What Vince Lombardi Showed Me

You might be wondering how I even know who Vince Lombardi is. Or you’re wondering yourself.

Well let me tell you…

I study anything that can help me succeed — in the markets and in life.

Famed NFL coach Vince Lombardi shows how anyone can succeed in a fair competition. With my goals in mind, his life is worth studying.

Every player in the NFL is talented. So in order to create a great football team out of the Green Bay Packers, Lombardi drove his players a little harder than the competition.

From Lombardi, I learned I needed drive to succeed. I needed to know the fundamentals of options and markets as well as anyone can. Then I needed to execute them flawlessly.

Of course, there will be factors beyond my control that affect stock prices. But that’s irrelevant. Per Lombardi, everything within my span of control must be flawless.

And I need to execute over and over again. Like football, trading can be a game of inches where small trades add up to big success in time.

This week, I am going to share a version of Lombardi’s “gentleman, this is a football,” speech.

We’re starting off with the basics here. So, in this version, I’ll explain what an option is, just to be sure everyone has the basic knowledge needed for success…

This Is an Option

Ladies and gentlemen, this is an option.

You may be familiar with options from your local farmers’ markets. Some farmers offer “farm shares” which are really options on their production.

Customers pay maybe $250 at the beginning of the season. The famer uses that capital to buy seed, supplies and meet operating costs. During the harvest, the farmer delivers shares of the farm’s produce to customers.

Deliveries are based on the harvest. You may get a bushel of tomatoes at the end of the season — or five bushels of tomatoes, 10 bushels of corn, and a box of radishes every week.

In other words, your “option” has unlimited potential upside.

Then again, maybe it’s a dry season and the farmer yields no crops. In this case, you lose your initial investment of $250.

Not ideal, but it’s actually another benefit of an option — you will never lose more than you paid to buy it.

It works the same with an option on a stock or an ETF. Options are a low-cost investment with limited risk and unlimited potential upside.

When you buy an option, you have the right to buy that stock or ETF at a predefined price for a certain amount of time.

Let’s say you think Apple (AAPL) will be a big winner in the next week if the market rallies. Like all investors, you have limited funds to commit to the trade. In this case, you have $500.

You could buy three shares of AAPL at about $160 a share. If AAPL goes up 10%, you can sell for a gain of $48, or $16 on each share.

On the other hand, if AAPL falls 20% — a possibility especially in this market — you would lose $96.

In other words, stocks provide unlimited upside but also uncertain downside.

To trade the idea of a 10% gain in AAPL, you could instead buy call options. These give you the right to buy AAPL at a specific price and by a certain date.

Specifically, the March 18 $175 call is trading for about $0.25 as I write this.

This contract allows you to buy 100 shares of AAPL at $175 at any time before the close on March 18. Because the contract covers 100 shares, you will pay $25 for the call, or $0.25 times 100.

If AAPL trades at $176, that option will be worth $1.00. You could sell your contract for $100 and record a $75 profit.

On the downside, if AAPL falls 20%, you would lose $25. Again, you can never lose more than the option costs to buy.

So with the same price moves, you’re looking at a $48 gain with shares versus a $75 gain with options — and a $96 loss versus a $25 loss.

Not to mention, you only paid $25 to enter the options trade versus $480 to own stock.

So options provide clear downside and unlimited upside, and generally with a lower upfront cost.

That, ladies and gentlemen, is an option.

Next week we will look at the types of options and in upcoming weeks I will explain how to use these powerful investment products to become the greatest investor you can be.

Regards,

Amber Hestla
Senior Analyst, True Options Masters

P.S. If you’re new to options, I can think of no better guide than our resident expert Chad Shoop and his Profit Calendar strategy.

Here’s the gist: Chad trades options on less than 1% of stocks on just a handful of days each year — and still beats the S&P 500 3-to-1.

What I love about Chad is how much care he puts into every strategy. He spent 10,000 hours creating the Profit Calendar before rolling it out to the public.

Those fortunate enough to get in right away have had the chance to land 53 triple-digit gains.

Now, he’s reopening access for a limited time…

If you’re just starting out, check out this strategy here. I think you’ll enjoy it.

Chart of the Day:
Can AAPL Run 10% in 8 Days?

(Click here to view larger image.)

You might be looking at Amber’s example option today and wondering if you could trade it. I know I was.

So let’s look at the chart and see what AAPL would have to do to make it to the $176 price that gets you a $75 return per contract on the option she called out.

From the pre-open price for AAPL as I write this, a rise to $176 per share represents a 9.29% gain in the stock. AAPL would have until the expiration date — next Friday, March 18 — to do that.

It seems like a lot. That would represent a capital inflow of about $240 billion.

But it’s certainly not impossible.

AAPL jumped about 7% in a single day back on February 24, when the broad market experienced a huge bounce.

With how oversold everything generally is right now, and the positive divergence we’re seeing in the momentum indicators on the daily chart, I think Amber’s example option could actually be worth trading.

Remember, you’re risking roughly $25 per contract for the chance to make $100 by next Friday. If what we’re seeing today is the start of a multiday rally, I like the odds of this trade making money.

Regards,

Mike Merson
Managing Editor, True Options Masters