Options Trading is a skill that requires a lot of learning and practice to get good at. Not only is there a plethora of strategies out there. But how you use them can vary from one stock or index to the next. For example, what works on Apple (AAPL) might not work well on Tesla Motors Inc (TSLA).
Let’s explore this topic by understanding exactly what options trading is.
What are options?
Although they sound complex, an option is simply a contract or right to buy or sell something under specific terms. A seller is given the choice of when to do something with that thing. The price you will be paid for is called the ‘premium’. And it’s usually cheap compared to what you could have sold that item for. As most traders say, your profits are unlimited, but your losses are.
If you think about it, most things in life are bought with some type of exchange. – i.e. work for money, food for money, and so forth.
How does options trading work?
It’s probably easiest to compare options/futures trading to popular games such as poker or gambling in general. You have to risk a small amount of money to win a potentially huge return. But you can also lose all of that.
In options trading, buying options is the same as going long on currency pairs. If by now you’ve been following my forex blog, then I assume you would understand what this means. But if not, then it’s the purchase of an asset with the hope that its price will rise instead of fall.
When someone goes short or ‘sells,’ they’re basically doing the opposite and expecting their asset. To drop in value rather than rise (i.e. betting against other traders).
Options give leverage because they are cheap compared to their underlying stock.
For example, if Apple was at $200 per share and you bought 100 shares at $2,000 – that’s $200 per share. For $500, you could buy five options, which would give you the right to purchase 100 shares of Apple. $200 each until the time limit is up (usually one year).
The difference comes when buying options because they are so much cheaper than stock.
If an option costs 10 cents, it gives you the right for ONE MONTH to BUY one share of Apple. At market price ($200) WITHOUT RISKING MORE THAN 10c PER SHARE! If Apple was worth more than what your option cost by next month, it would make money.
However, if they went down in value, your loss would also be capped at only 10 cents.
An option spread is a strategy where you buy and sell different options on similar stock. But with contrasting strike prices and expiration dates. If appropriately executed, this will limit your losses or give you more significant gains. For example, suppose AAPL is trading at $100 per share; you might buy a 100 put for $5 and sell a 95 put for $2.50 for a net credit of about $1.75. If AAPL goes to zero (0) before it expires, you’ll make around 175% of your initial investment (lower fees). However, if AAPL doesn’t go below 95 by expiration, then you’ll only lose the small premium of the 95 puts, or $2.50.
Option spreads work well with low volatility stocks because the premiums on all puts will be lower. They also work well when you have a directional bias toward a particular direction for a stock. Meaning that you expect it to go up or down by the expiration date.
Dividend capture strategy
If you’re going to buy a derivative based on some underlying security (like AAPL). Why not just buy the actual security and collect dividends while your position gains value? Simply buying AAPL stock instead of collecting royalties from options may be cheaper. If no dividend is paid out at the time. However, if the company is handing out dividends, this is an excellent way to boost your total return.
To do this, buy AAPL stock at the beginning of the month before the dividend payments are issued. And sell it right after you receive them. You can even do this multiple times in a year if there are other dividends paid out. Because the strategy only puts you in cash temporarily.
However, long-term investors may want to skip this strategy. Because it can be more expensive than simply owning shares of AAPL without generating dividends.
This strategy involves selling calls against your existing holdings to generate extra income. That you wouldn’t have otherwise gotten if you didn’t do something like this. Put, when someone considers buying your stock, you sell them the option to do so at a set price.
As an example, if AAPL is trading right now at $100, but you think it might not go above $110 by expiration. Then maybe someone will want to buy your shares for $110. If this happens, you’ll get paid around $10 ($110 – $100) per share they purchased using the strategy mentioned above.
Of course, if AAPL goes up or down, there may be no buyers or sellers until the expiration date. Because people are waiting to see what will happen with the stock price. Selling covered calls can also limit your gains on some stocks. Because you keep rewarding yourself every time you do this (limit upside potential).
It’s an exciting strategy that can help you protect your downside when trading derivative securities like options. Let’s say AAPL is trading at $100 per share right now. But there are rumours that something terrible might happen to it soon.
It sounds like a great time to buy put options for protection. So you don’t lose much money if the stock goes down after this bad news come out.
The general idea with this strategy is similar to simply buying insurance for anything else in your life.
Except that you pay extra premiums for this kind of protection if there aren’t any sellers. Then good luck because that means that there is a high demand for these kinds of strategies right now.
Why not try some of these strategies with Saxo? They offer a free demo trading account that makes it easy for you to practice. New strategies without risking your cash flow.