Before we get started, please understand this article is to orient you to the opportunities. This is in no way a “How to” guide, as there are more dynamics at work. The goal is to hope you will learn more about options.
Options allow you to limit your risk
Options are a unique vehicle for investing in that you can pair two different options and limit your risk directionally. This is called spread trading. For example, if you are bullish on the stock market, you may sell a put lower than the market and then by one of few strike prices beneath the option you sold. What this is allows is for you to profit by selling an option but also protecting the risk if the trade goes against you. Here is an example, if the $SPY is at $265.00:
Sell 1 put at the $245 strike, approximately 45 days out for $1.78
Buy 1 put at the $240 strike, at the same expiration for $1.30
The potential profit is $48 dollars, and your risk in the trade is $452.00. That is a 10% return for 45 days. Now, this is somewhat oversimplified, but bear with me. The market is currently at $265 and your short strike is $20 below the market. That equates to 200 points on the S&P 500 index. That means the market has to go down that much, and stay down, at the time of expiration. What are the odds of that happening? About 16%. You have an 84% of the market staying above that amount.
There are many places to learn more about how to trade vertical spreads. You will have to invest some time and effort, but as you can see in the example above there is profit to be made. If you make 10% every 45 days (not that I recommend holding these options to expiration), you wonder why people invest a lot more, have a lot more risk, only to make about 8% per year which is the average S&P gain over time.
Options allow you trade without direction
Option traders can also trade without bias as to the direction of the market. One of the simplest trades involves two short vertical spreads as I explained under header number one. To make this a nondirectional trade, one would simply add a short call spread at the same time they traded the short-put spread. This is called an iron Condor. Here’s the trade you would add to the trade we talked about above to complete your iron Condor trade:
Sell 1 call at the $275 strike, at the same expiration for $1.69
Buy 1 call at the $280 strike, at the same expiration for $0.77
Your profit on this trade is $92.00. Add this amount to your $48 in the example above and your potential profit is $140.00. Now the interesting part is the risk on your short put vertical and the short call vertical is the same risk. Why? Because the market can be up at expiration, or down at expiration, but it can’t be both. Therefore, your risk in the trade is now $360.00. This is where the magic happens. Now your profit is $140, your risk is $360 and your return is 39% (rounded).
If your underlying stock stays between $245 and $275, you make money. Without getting into the nitty-gritty, you can see the potential for profit is great, with no bias towards direction. This is not to say you will profit, because there are other factors at play with options. Volatility, interest rates, time to expiration, etc. For the other benefit of this type of trade, let’s move to #3.
Options Allow you to profit in your sleep
Options which are sold gives the seller the benefit of positive theta. Theta is one of the option Greeks which everybody should know about. Positive theta of say, one dollar, would yield you approximately one dollar a day, or $30 per month. If you own a stock that you’re holding anyway, why not write a call against it and make that money each month? There’s quite a bit to options trading and a lot of people will tell you that is more risky than stock. Let me pose a question. If you were long stock that you purchase for $10, you would have $1000 a risk if you owned 100 shares. If you were to make $30 per month for 12 months, you would profit $360 on your covered calls. All things being equal your risk would only be $640 at the end of your first year. After two and half years roughly you own the stock for free. If you made $30 a month for the rest of your life, you can easily see that positive theta has many benefits even if you are a buy and hold stock purchaser.
Options can insure your portfolio (and other things!)
Many people use long puts to ensure portfolio against downside movement. This is a good strategy if you’re worried about a short-term event, say a few days. The problem is if you’re worried about an event so is the rest of the world. Concern about the event could increase the volatility and thus the price of the option. Once the event ends, the volatilities deflated in the option becomes very cheap. This makes insurance using options a little more expensive. Buying long puts creates negative theta, which means you’re losing money each day. This is not the best strategy, you options traders and stock owners should be aware of the possibility of insuring your portfolio.
Options can simulate stock purchases (for much less!)
Most people do not know the you can simulate a long stock purchase for much less than the cost of ownership of that stock. This is done by buying a long call and selling a short put. If you were to purchase of Twitter by now at approximately $31, a $30 strike long call and short put it would cost about $220 and hundred shares in equivalent stock. Because you have a short put your risk is a little higher in that the margin would be around $1000. Your risk in the underlying stock would be $3000. Therefore, you have about a 60% reduction in risk. There is more to this and that this is also a negative theta training, however, if you expect a short move to the other side in a stock, this may be a way to make that play with last investment.
The intention of this article is not to make options traders out of everybody, but to make everybody aware of some of the benefits of options. There is much more to options and can be covered in a single blog post. There are many ways to learn options, one of the best however, is to watch TastyTrade. I would love to make the videos myself, the wife created the wheel and somebody’s doing such a good job of it now.
Please understand that options involve risk, just as stock purchases. Please read the OIC’s document characteristics and risks of standardized options for more information.