Options Trading: The Definitive Guide on the Basics

Author: Steven M. Sears | Last Updated: July 3, 2019

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Introduction

When it comes to investing and the financial markets, what you don’t know can hurt you – or help you - if you take the effort to understand what you don’t know. But finding the right information is often hard, and finding information that is useful is often even harder. The difficulty exponentially increases when trying to find useful information that is easy to understand about complex investments like options trading. To help, we have assembled this primer on options trading that will introduce investors to key concepts and trading strategies.

Since the financial crisis, options trading has emerged as one of the fastest growing areas in the markets. On any given day, anywhere from 16 million to 20 million contracts trade, representing 1.6 billion to 2 billion shares of stock. If something happens to truly startle investors, options trading volumes are sharply higher because the options market is where the so-called smart money comes to manage the risk and reward of owning stocks.

Yet, what happens in the options market is often a mystery to most investors, and the activity in the market is misunderstood by many more. But over the past 20 years, options trading has grown in such importance, and the trading volumes are now so large, that what happens in the options market often influences – and sometimes drives – what happens in the stock market. In other words, options are no longer optional. Options have become so critical to investment management that many money managers think you cannot run an investment portfolio without using puts and calls. Options dealers – these are the specialized traders who make markets – have for a long time, been some of the largest stock traders in the nation. Every time puts and calls traded, options dealers traded stocks to manage the risk. The nation’s major stock exchanges finally caught on to that fact, and now the New York Stock Exchange and NASDAQ markets, own multiple options exchanges. In fact, derivatives trading is now more lucrative for exchanges than stock trading.

average daily options volume chart

https://www.wsj.com/articles/the-day-traders-are-back-now-playing-with-options-11557572401

Yet, the options market remains wildly misunderstood, and that is understandable. The financial press corps loves any story that involves people either making a load of money in a short time, or better yet losing a ton of money in an even shorter time. A story about investors using options to increase returns and reduce risk is not nearly as exciting as one about investors who lost money trading complicated options strategies or betting that the CBOE Volatility Index, or VIX, will surge and stocks will decline. Besides, many investors have dabbled in options and lost money. This was especially true before 2000 when the options traded in open-outcry trading pits and prices were controlled by dealers who shouted a lot and wore funny colored jackets. But since 2000, exchanges have shifted options to sophisticated, electronic trading systems that have dramatically improved prices and liquidity. There is still risk inherent in options, but there is also risk in driving a car, crossing the street or eating too much red meat and not getting enough exercise.

But there is a secret to options trading that is well known to institutional investors, including mutual fund managers. We’re going to share those secrets and show you a different approach to options trading. We’re going to show you how some of the best investors use options to reduce risk and to better invest in the stock market. We’re not necessarily interested in using options to make a ton of money overnight, although we have nothing against that. Instead, we are interested in using options to try to perpetually hit proverbial singles and doubles, to borrow a baseball phrase. Sometimes, you’ll hit some triples and homeruns, but that’s not the goal of most successful options traders. The goal is to increase the returns of owning stocks without sharply increasing risk, while never doing anything that causes you to lose so much money that you get knocked out of the markets.

Even if you decide that options are not for you, it is important to understand options. The options market influences the price of every stock, index and exchange-traded fund. Why? The options market is the place where the most sophisticated investors come to reveal their thoughts about what may happen in the stock market. They do this by trading bearish puts and bullish calls to express investment views about the future directions of stocks. The volume of options trading is so large on any given day that it requires dealers to trade massive amounts of stocks and futures.

Anyone who knows how to read options trading patterns instantly has an advantage over other investors who don’t understand this market and only understand stocks. Anyone who uses that knowledge to trade options often more successfully invests in stocks.

In fairness, the options market scares a lot of people, and the world of puts and calls often suffers from a bad reputation. Some investors have been lured into the options market by charlatans who told them that they could use options to make a lot of money in a short time. In truth, the only people who ever seem to make a lot of money in a short time are the hucksters selling snake oil to investors who want to believe what they hear. These hucksters make their money selling so-called trading secrets that usually turn out to be sheer nonsense. We’re going to steer clear of that bunk and focus on time-honored approaches that you can use to become a better investor.

Options trading is as much a discipline, and way of thinking, as it is a way of trading. The market is animated by a philosophy that values risk over reward, probability over possibility, and a sense that the market mob is often wrong but never in doubt. Good options traders tend to make great stock investors. By learning to think about probabilities, risk and volatility, investors tend to think more clearly about stocks. By the time you are done reading our options primer, you will know how you can use options to buy stocks for less than they are trading, how to sell stocks for more than they are trading, and how to get paid just for agreeing to buy and sell stocks. You’ll also have the workings of a risk-adjusted framework that you can use to better evaluate risk throughout your financial life.

Options 101: Building a Foundation

It’s important to establish some basic facts. This may seem very elementary, but even the most sophisticated investors spend time defining terms with each other. They do this because the language of investing is not uniform, especially at higher levels. Different terms mean different things to different people.

Basics of Options Trading infographic

Options give investors the right to buy and sell stocks at predetermined prices within set times. Options are contracts with standardized terms. This reflects the market’s historical origin when investors bought and sold options contracts. Those paper contracts specified the name of the company, the expiration date of the contract, and the strike price. The terminology continues to exist even though options contracts are now electronically traded.

These are the key concepts of standardized options contracts:

When investors want to buy stocks, they buy calls, which increase in value as stock prices rise.

When investors are worried that stocks will decline, they buy puts, which increase in value when stock prices decline.

All puts and calls have strike prices. The strike price references the value of the underlying, or associated, stock. A call or put with a $100 strike price references a $100 stock.

All options contracts exist in a state of “moneyness” that refers to how close, or how far, the strike price is to the underlying security’s market price. When the strike price matches the associated security’s market price, an option is said to be “at the money.” An example of this if you have a $100 call, and the underlying stock is at $100. When the stock price is higher than the strike price, the option is “in the money.” An example of this is if you have a $50 call and the underlying stock is at $100.

When the strike price is below the stock price, the options contract is “out of the money.” An example of this is if you have a $100 call and the underlying stock is at $200.

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All options contracts have expiration dates. After a certain period of time, the options contract expires and no longer has any value.

Options have an expiration cycle. The expiration cycles range from one week to about two years. Investors can buy or sell options that expire in one week out to two years. Most trading, however, is centered on options that expire in three-months or less. The interest in shorter expirations reflects how closely institutional investors – think mutual funds and hedge funds and pension funds – are focused on corporate earnings reports and their own quarterly performance. The shorter-dated options also have the most liquidity. Why? It’s much easier for dealers to anticipate what might happen in a few months, as opposed to a few years.

Puts and calls are the building blocks of the options market, and the foundation of a series of trading strategies that anyone can use to try to bend the chaos of the stock market to their investment objectives.

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Have a trading plan, and protect yourself. I am big on risk management...

— Jay Soloff

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Options Can Be Risky

options risk illustration

It is a cold fact that options are not suitable for everyone. Investors should first have experience investing in stocks before venturing into the options market. After all, options derive their value from the underlying stocks. If you don’t understand the underlying stocks, and the businesses that drive stock prices, you will have great difficulties understanding options.

Options require more care and study than just buying stocks. With stocks, investors can simply buy and hold, and hope that time redeems their decision. With options, investors have to be right on several key points, including the underlying stock’s direction, and on a slew of factors specific to the chosen option, including expiration, strike price and volatility.

For those reasons, and others related to securities regulations, anyone who wants to trade options must be approved by their brokerage firm, which will want to know about an investor’s investment experience, any previous experience with options, how much money they have, and what their goals are or using options. Some investors use options to hedge stocks or to speculate on price movements. Others use options to enhance yields and to generate income. Some investors use options for more aggressive purposes, but the truth is that the most successful investors tend to shy away from using options for speculative purposes like wagering on takeovers, or price movements in stocks. The vast majority of what occurs in the options market on a daily basis is simple, basic portfolio management strategies that are frankly rather boring. For example, many mutual fund managers regularly sell call options against stocks that they own to increase returns. If they buy a stock at $20, and have a price target of $30, the managers will keep selling $30 calls to get paid more money just for owning the stock. It’s not very exciting, but it increases returns without increasing risk, and that’s the main goal of successful investing.

Our goal with this primer on the options market is give you a workable understanding of this important market. By the time you are done reading, you will understand key concepts, including the importance of volatility levels, and you will be grounded in several key options strategies.

how you interpret the price of an option, is really where the opportunity is

— Felix Frey

Founder of OptionsGeek

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Knowing you Options Margin of Safety

The ABCs of Options

ABC of options infographic

Every day, just as the stock market opens in New York, so does the options market. Almost every stock, exchange-traded fund, and index also trades in options market. There are some listing rules that a security must satisfy for an options listing, but all major stocks, including Apple, Amazon, Microsoft, General Electric and so on trade in the options market. Unlike the two primary stock markets, there are about 16 options exchanges, many of which are owned by the New York Stock Exchange and NASDAQ. The options markets are regulated by the Securities and Exchange Commission, just like the stock market.

Options have a reputation for being hard to understand, but that is because they are often poorly explained. So, we’re going to pull back a bit and take a different approach to the topic. Everyone intuitively knows and understands that people buy and sell stocks issued by companies. A share of stock makes an investor an owner in a specific company, and sometimes the company even pays a dividend to common stock shareholders.

Because Wall Street is always looking for ways to make money, someone long ago realized that if people wanted to buy and sell stocks that they would also be willing to buy and sell the rights to buy and sell those stocks. It is that right to buy or sell stock that is the essence of the options market.

When investors want to buy stock within a certain time and price, they buy a call option. An easy way to remember this is to think of a call as giving investors the right to “call in” a stock.

When investors are worried that a stock may decline in value, they buy a put option. An easy way to remember this is to think of a put as giving investors the right to “put” a stock to someone else.

Let's make an important distinction. Options give investors the right, but not the obligation, to buy and sell stocks at pre-determined prices and times. Owning an options contract does not mean that you have to buy or sell the associated stock. You can simply buy or sell the options contract, and close the position at a loss or gain. Many investors do just that because of the leveraged nature of options. The percentage returns trading options often dwarfs the returns that are available in the stock market. If a stock price advances 10%, for example, the value of a call could increase 100% or more.

Remember, each options contract represents 100 shares of the underlying security. So, if you own one call, you own the right to buy 100 shares of stock. If you own one put, you own the right to sell 100 shares of stock. If you own five contracts, you own the equivalent of 500 shares of stock. Don’t forget this. A lot of errors are made because investors buy or sell too many contracts, forgetting this basic fact about contract size.

Unlike stocks that are issued by companies and exist forever, provided there are no extraordinary moments in the life of the company, all options expire. Options are known as “wasting assets.” They lose a little bit of value as each day passes and they approach their expiration date. Options expire anywhere from a week to more than two years. When options expire, they no longer exist.

Now, let’s get into some concrete examples.

Options are bought and sold, just like stocks, of course, but there is often a twist.

If you buy a call, you are expressing a view that the underlying security will advance. If you sell the call, you think the underlying stock will not advance.

If you buy a put, you are expressing a view that the underlying security will decline. If you sell the put, you think the underlying stock will advance.

The difference between long and short options is an elementary, but critical, distinction. Anytime that you enter an options order with a brokerage firm, you will have to indicate if you are selling to open, or selling to close, or buying to open, or buying to close.

Is it better to be a buyer or seller? Great question. The options market suffers from an ongoing debate about whether it is better to buy options or sell options. Some investors contend that it is more profitable to sell options. Why? Because options prices are embedded with an equity risk premium, plus they lose value each day. This quality of options is like catnip to many investors who try to profit from “time decay,” which describes the phenomenon of options losing value as each day passes. Other investors like buying options because they don’t want to limit profits to the premium received for selling a put or call. If you sell a $2 put, for example, you only earn $2. But if you buy a $2 call, and the underlying stock advances to $10, you could, for example, make $8. In practice, most investors buy and sell. Some investors have favored strategies, which we will cover in detail, but disagreement in markets is always healthy as it ensures that there is generally an equilibrium between buyers and sellers.

Volatility

volatility illustration

The price of an options contract is determined by the price of the underlying security, how much time exists until the contract expires, interest rates, and volatility. Some investors like to talk about “the Greeks,” which is a series of esoteric measures that focus on how an options contract is influenced by Delta (changes in the underlying stock price), Gamma (a measure of how the options price is influenced by changes in Delta), Vega (how the options price is influenced by changes in volatility), Rho (how the options price is influenced by interest rates) and Theta (how much value an options price loses as each day passes to expiration).

In practice, it is rare to hear anyone but professional investors ever discuss “the Greeks.” Everyone is always focused on theta, or time decay, because so many investors like to sell options to profit from the phenomenon, but all options traders, from novices to professionals, are always focused on volatility.

options pricing Greeks infographic

Volatility is arguably the most important determinant of price. Why? Of all the measures that influence an options price, volatility is a combination of art and science. It is influenced by current trading patterns, past trading patterns, and even the assumptions of dealer pricing models about what may happen to the underlying stock. Because volatility can rise or fall, anyone who can correctly anticipate the trajectory has a great edge over everyone else. The advantage is basically the options equivalent of buying low and selling high, or selling high and buying low.

Volatility is the essence of the options market.

There are two types of volatility in the options market: realized, or historic, and implied.

Volatility, realized and implied, is measured from 1% to more than 100%. The primary proxy for volatility, the VIX, has a long-term average of about 19%. An industrial stock may have an implied volatility of about 10%, while a biotechnology stock with an experimental drug awaiting government approval could have a volatility level at 100% or higher.

As a rule, many investors like buying options that have low volatility and they like selling options that have high volatility. Low volatility means options are generally trading without a fear or greed premium. So, anyone who buys a low volatility option is not paying extra to buy the put or call. When stock prices are high, and the associated options volatility is low, some investors use options as stock surrogates. They might sell their stock, lock in profits, and replace the position, with a low volatility call.

High volatility options are the opposite. It means that a put or call is priced with a greed or fear premium. Investors usually want to sell “high vol” puts and calls. The reasoning is basic. High volatility usually reflects an event, like corporate earnings, and options dealers tend to increase volatility because they don’t know what will happen to the stock after the anticipated event occurs. After the event, however, the high volatility usually leaves the options contract, and the volatility level drops to the usual level.

Realized Volatility

All stocks, like all people, have a history. Stock prices are the expression of all previous earnings reports, good and bad. All stocks are impacted by economic cycles, the release of economic data, the decisions and actions of competitors, and even government policy. All of that is reflected in a company’s stock price, and also in the realized volatility of the stock’s options contracts. Realized volatility, also called historical volatility, is a mathematical measure of what happened to the stock in the past.

Every options contract has a realized volatility. You have to know this to better understand implied volatility that is concerned with the future. The difference between realized and implied volatility is one way that many investors use to determine if options contracts are too expensive or inexpensive or priced fairly. If an options contract has a realized volatility of 16%, but an implied volatility of 32%, investors would wonder what caused the discrepancy. They would then analyze the stock and options contract to determine the answer to the volatility puzzle and then select the best strategy to trade.

Think of realized volatility as a giant magnet. Think of implied volatility as a metal bar that is always advancing into the future, while always remaining under the influence of realized volatility. The two types of volatility are interrelated, a fact that eludes many investors.

historical and implied volatility chart

Source: Optionseducation.org

https://www.optionseducation.org/toolsoptionquotes/historical-and-implied-volatility

Consider the VIX.

Since the Global Financial Crisis of 2007 and 2008, volatility, as measured by VIX, often has been unusually low. VIX has often traded around 12%, seemingly shrugging off major disruptive events, including Brexit, a trade war between America and China, and the like that seem so harmful to stock prices. Pundits and financial media invariably point to VIX as a sign that investors are complacent in the face of risk, when there is a more technical, accurate, explanation. When stock prices rise, the pricing algorithms that are used to price options reason that the future will be like the past. When realized volatility is low, it drags down implied volatility.

When VIX, for example, was near 12%, 20-day Standard & Poor’s 500 Index realized volatility was at 6.86%, and 60-day volatility was 7.13%. The 200-day realized volatility was 10.3%. Against that backdrop of realized volatility, VIX was clearly not broken. VIX was working just fine, and in fact some experienced investors were concerned that VIX was so much higher than the realized volatility of the S&P 500.

Implied Volatility

If the options market is the heartbeat of the stock market, implied volatility is the heartbeat of the options market. For all of the options market’s complexities, and whirling parts, understanding, and trying to anticipate, what will happen to implied volatility is perhaps paramount.

Almost all investors have heard the expression that the stock market is a discounting mechanism that is always concerned with what may happen in the future. The options market’s equivalent discounting mechanism is implied volatility.

Every day, in real time, the implied volatility of every security in the market is in motion as it reflects what is happening across the financial markets.

Implied volatility levels represent the options market’s collective wisdom on what may happen to the underlying security over the relevant contract’s expiration cycle. If the contract’s implied volatility level is high – always check the SPDR S&P 500 ETF Trust (SPY) and VIX to create a baseline – it indicates that investors expect the associated security to make a sharp move. The opposite is true if implied volatility is low. Many options trades fall apart because investors correctly anticipated what would directionally happen to a stock without ever checking the option’s implied volatility level. Almost always, implied volatility rises before events, including earnings, reflecting the heightened expectation that the stock will move.

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The Nature of Volatility

nature of volitility image

It’s not enough to understand realized and implied volatility. You have to understand how volatility behaves. Volatility is a mean reverting asset. If an options contract is priced with an implied volatility of 55%, but realized volatility is 40%, it is generally believed that the contract’s volatility will ultimately return to the historic average. That’s why many investors like to sell high volatility to play and profit from the “reversion to the mean.” The opposite is true. If options implied volatility is very low compared to realized volatility, they buy it and think it will revert to the mean.

Think of volatility like a rubber band. When it gets stretched out, and seems like it is about to break, it invariably loses all of the tension and returns to a normal level. Such is the baseline assumption about volatility. Yes, it is true that the rubber band sometimes breaks – say because news dictates a new, higher volatility regime – but the rubber band metaphor is a baseline view of veteran options traders.

The Fear Gauge

VIX options trade at CBOE

VIX options trade at CBOE.

Source: CBOE

The VIX has become as popular as the Dow Jones Industrial Average. The VIX, also known as the stock market’s fear gauge, is widely cited to determine if investors are complacent, or afraid, of what may happen to stocks. Yet, the VIX is wildly misunderstood even though it is the primary proxy for volatility.

VIX was designed to provide investors with an indication of what the options market thinks will happen to the Standard & Poor’s 500 Index over the next 30 days. Many investors think the VIX expresses some more penetrating, deeper opinion of the stock market, but that’s not true.

Moreover, VIX’s value is determined by measuring the implied volatility of a series of puts and calls on the S&P 500 index. The calculation is complicated, but the value is expressed in a simple, easy to understand number. Historically, VIX has averaged around 19, which means the S&P 500 Index is basically expected by the options market to move 1.19% each day. Investors should remember VIX’s long-term average as a baseline reading for volatility. When VIX Is very low, it broadly indicates that options premiums are inexpensive, and perhaps worth buying. When VIX is high, it indicates that options premiums are expensive, and perhaps worth selling.

Here’s a trader’s ditty that Steven M. Sears, Barron’s options columnist, developed to teach stock investors how to understand how to use the fear gauge. When VIX is high, it’s time to buy, and when VIX is low, time to go. His phraseology is simply an options-centric play on Warren Buffett’s dictum to be greedy when others are fearful and fearful when others are greedy.

When VIX is high, say around 40, it means that investors are afraid and buying puts to hedge stocks against future declines. In those situations, many options investors like to “sell fear.” They will sell expensive bearish put options to frightened investors, enabling them to hedge. The put sellers get paid a big “fear premium” for simply agreeing to buy stocks at lower prices. Investors also respond to high VIX readings by buying stocks. When VIX set an all-time high of about 90 in October 2008, one of the darkest days in modern market history, it indicated widespread fear. Anyone who bought stocks during that extraordinarily sharp decline likely realized incredible profits. After all, stocks are sharply higher today than in 2008 when it seemed the financial system could collapse.

When VIX is low, say around 12, it means that investors are relatively complacent about the future of stocks. Hence, bullish call premiums are often not expensive. In these instances, investors buy calls as surrogates for stocks. Some investors even take profits on stocks, and replace them with inexpensive calls.

VIX index and S&P 500 index since 1990

Source: CBOE

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Starting Strategies

A veteran options strategist, someone who has advised thousands of investors and also contributed to the growth of the options market, likes to say that there is a reason why there are so many ice cream flavors. Everyone can choose the flavor that they like best. The same is true with trading strategies. Options create options. The number of strategies is mind boggling, but we’re going to focus on core strategies that will help investors achieve critical investment objectives.

In the strategy examples, we will use, when we can, actual stocks and exchange traded funds and real market prices. Obviously, prices change, but it is easier to understand options strategies using real companies and real numbers and showing how investors really use options.

Rather than focusing on options for the sake of options, we’re going to focus on using options to control stocks, which is arguably the way most investors use puts and calls.

How would you like to get paid by the options market for buying stock? Would you like to make money for agreeing to sell stocks at higher prices? How about increasing the returns on stocks that you already own? All of those noble outcomes are possible simply by selling puts and calls. The strategies have long been used by sophisticated investors, and they are increasingly becoming popular. In 2016, Morningstar, which millions of individuals rely on to evaluate mutual funds, created a category for options-trading funds that sell puts and calls as part of their primary strategy. Many mutual funds are changing their investment charters to permit fund managers to use options to reshape risk and generate income. Pension funds are also increasingly using options. Since the financial crisis, some of those massive funds have fired stock managers and instead invested in funds that sell puts and calls. Two of the world’s largest financial firms, Goldman Sachs and BlackRock have for years told their clients that options volatility is an asset just like stocks and bond. What is the strategy both of those firms recommend? Selling puts and calls.

But before we get into some of the most widely used strategies it is important to understand what it means to simply buy a bullish call or bearish put.

One of the truths of trading: You never know what is going to happen next...keep in mind that martyr is not part of your job description

— John Carter

Founder and President of Simpler Trading

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My Top 3 Favorite Option Trading Strategies

A Long Call and Put

Investors buy calls when they think a stock will rise. It’s that simple. If a stock is trading at $10, and they buy a $12 call for $2, and the stock rallies to $17 on earnings, the call is worth $5.

A call option, as you remember, gives you the right, but not the obligation, to buy 100 shares for less money than it costs to buy the stock.

Why would someone buy a call? Investors buy calls when they think a stock price will advance. They may opt for a call over buying the actual stock because they cannot afford to buy the stock, or they want to “rent” the stock.

Consider CVS Health. In advance of an investor day meeting, investors bought June $52.50 calls that expire June 7 for $1.58 when the stock was at $52.30. At $55, the calls are worth $2.50. Should the stock be below $52.50 at expiration, the money spent on the trade is lost.

Conversely, investors buy puts when they think a stock will decline, or they are worried that it might do just that. If a stock is trading at $10, and they buy an $8 put for $2, and the stock declines to $4 on earnings, the put is worth $4. Puts increase in value when stock prices decline.

Consider Costco. Investors were nervous before a recent earnings report so they bought puts to hedge stock and profit from a potential decline.

When Costco’s stock was at $248.53, some investors bought Costco’s June $242.50 put options that expire June 7 for $3.50. If the stock declined to, say, $235, the puts would be worth $7.50. If stock advanced on earnings, proving all of the concerns to be misplaced, the money spent on the put is lost if the stock is above the strike price at expiration.

Short Calls and Puts

Those long call and long put trades happen all the time. They are often speculative in anticipation that something will happen to make a stock sharply react. That’s why the expiration dates of the contracts tend to be closely matched with whatever event is scheduled to occur.

But the vast majority of action in the options market is likely attributable to investors who are strategically using options to better control stocks that they own or want to own.

Now, think of your investment portfolio. You probably own stocks that are idling, or that have lagged the market. You also probably have a list of stocks that you would like to buy, or sell. The options market can you help do all of that a little bit better without really increasing investment risks.

Overwriting: Increase Stock Returns and Sell Above the Market

The strategy refers to selling calls against stocks that an investor already owns. Investors “overwrite” when they want to increase the return on stocks that they own, or they want to get paid to sell their stock at a higher price.

Consider Bank of America. The widely held stock, like many other bank stocks, has lately traded in a narrow price range. The stock has been pushed around by worries about a recession and uncertainty about interest rates that are important to bank earnings. Rather than letting the stock languish, some investors sold calls against their positions to increase returns.

When the stock was around $26 in May, investors sold 20,000 June $28 calls for 20 cents. The trade expresses a view that the stock will not advance above $28 before the calls expire. If that is true, the investor – it’s obviously a major institution because 20,000 calls is the equivalent of 2 million shares of stock - can keep the call premium. If the stock is above the $28 strike price at expiration, however, the investor is obligated to sell the stock at $28 – though the effective price is $28.20.

The 20-cent options premium is really equal to $20 per contract. Remember, each options contract represents 100 shares of stock. Within that context, selling calls against long stock can make a real difference.

What’s the risk?

If the stock price suddenly surges, and it is above the $28 strike price at expiration, investors are obligated to sell the stock at $28. This is true even if the stock is at $40. Of course, investors could cover the short call, but they would pay top dollar. Should the stock be at $40, the $28 call is worth $12.

The over-write strategy is used by everyone from mutual fund managers to individual investors. It’s popular with money managers who tend to have price targets on every stock that they buy. In other words, smart investors have already set a sale price when they buy a stock.

Imagine that a mutual fund manager bought a stock at $20. The manager’s financial model indicates that the stock is fully valued at $30. Rather than just waiting for the stock to rise to $30, many fund managers systematically sell $30 strike calls against the stock to enhance income—and get paid for owning the stock.

The over-write is such a mainstay strategy that options that expire in three months are often said to form the buy-write or over-write market. It is here, three months into the future, that prices are often the best and liquidity is often the deepest. Investors will still do just fine at closer expirations, and even more-distant ones, but three months out is a market sweet spot.

The standard income-generation trade is selling options that expire in three- to six-months and that have strike prices 5% to 10% higher than the current stock price. Other investors sell calls that expire weekly, reasoning that they can make more money repeatedly selling calls, but that is an approach best left to more seasoned traders.

A good rule of thumb is trying to only sell options that are priced at $1 or more. It is also important to understand that you may miss out on a big rally if you sell calls against a stock. This is the principal drawback to the strategy. In the market, anyone who has a hot stock called away from them is said to experience “upside regret.”

When you sell a call, you are essentially saying that you do not think a stock price will rise above the call strike price. In other words, you think the associated stock is stalled and unlikely to advance. Sometimes this works out beautifully, and you simply pocket the money that you received for selling the call and collect a nice income.

But sometimes the unexpected happens—and this is why you should never sell call options on stocks you are not willing to sell.

Put Writes: How to Buy Stocks Below the Market

At any moment, the options market is willing to pay investors for agreeing to buy stocks at lower prices. If that sounds appealing, all you have to do is sell a downside put on a stock that you want to own. This is an example of the increasingly popular cash-secured put strategy.

Imagine a hot stock that you want to buy, but you are concerned about paying top price. Consider Apple, which is one of the most-widely owned stocks, and that always seems to be dancing around a 52-week high stock price. You can get the options market to pay you to buy the stock at a lower price. How? You just sell a put.

In June, when Apple was recently trading around $175, an investor could sell Apple’s August $170 put for $7.70.

If the stock was above the $170 put strike price at expiration, you get to keep the money received for selling the put. If the stock is below the strike price at expiration, you get to buy the stock at the strike price at $170, though the effective price is $162.30 (the strike price less the put premium.)

The strategy tends to work so well that various studies have found that selling puts outperforms the classic buy-and-hold stock strategy.

How is that possible?

Selling puts monetizes the fear of other investors. The natural position of most investors is long. They buy stocks because they want to profit from an advance. Some investors like to hedge their stocks and leave nothing to chance. So, selling puts is a way to get paid by investors who are afraid of a decline. The risk—which can be managed—is that you must be willing to buy the associated stock if the price drops below the strike price.

If Apple’s stock price was at say $150 at expiration, you would have to buy the stock at the $170 strike price, or cover the put at top dollar. This is the key risk to selling puts on stocks. You have to be willing to buy the stock. Never sell a put on a stock you are not willing to buy.

The Importance of Understanding Tradable Events

Whenever you trade options—and this applies equally to puts and calls—you must understand what stock-centric events are covered by the expiration date. Events move stocks. Events represent risk. Events represent opportunity. If you are selling a put that expires in one month, you must try to understand everything that is scheduled to occur before the put expires. You must have a view of how a stock might respond to those events before trading any put or call. After all, options do not exist in their own world. They are derivatives, and they derive their value and life from the associated stocks, their sectors, and the broad market.

The Rule of 16

The options market is filled with professional traders who have advanced degrees in mathematics, physics, and high finance, but there’s a secret that no one wants you to know. Most traders and strategists spend the day doing one very simple bit of division. All day long, these traders divide an options contract’s implied volatility by 16 to determine how likely the associated security is to move until expiration. The calculation also helps to determine if an option is expensive or inexpensive.

If implied volatility— remember, that is what the options market thinks will happen in the future—is 16, it means the stock is priced to move 1% each day until expiration. At 32%, it means a 2% move and so on.

The information is used for practical purpose. Do you think the security will move more or less than the amount priced by the associated put or call? If you think not, consider selling options. If you think so, consider buying them. If you don’t trade options, use the Rule of 16 to see what the options market is pricing, and use the information to help you better buy stocks.

You might be wondering why it is that 16 is used in the calculation. Great question. Sixteen is the square root of the number of trading days in a year, so the rule helps to contextualize how a stock might move during the specified expiration cycle of the options contract.

Common Mistakes: How to Mitigate Risk

illustration of losing a trade

The former head of a major derivatives desk at a large European bank, a fellow with a doctorate in mathematics, once said he liked to spend the day constructing complicated trading strategies that included a lot of elegant mathematical formulas. The exercise appealed to his love of math. But at the end of the day, the senior trader confessed that he wasn’t sure if his trading profits were any better than just selling or buying a put or call. Remember this story the next time you hear someone talking about some complicated options strategy that will supposedly make money no matter what happens to the associated security.

The number one mistake that most investors make in the options market is that they get greedy, overconfident, intellectually arrogant, and they complicate their approach. The dean of Wall Street’s options strategists, Michael Schwartz, Oppenheimer & Co’s chief options strategy, counsels his to clients to always apply the KISS Principle. What’s that? Keep It Simple, Sweetheart.

In other words, understand your investment objective and find the simplest, cleanest way to achieve the goal. Leave the esoteric trading strategies with multiple moving parts to institutional investors. If you cannot help yourself, and you feel drawn to more complex strategies, including butterflies and iron condors, wait until you have established a track record of successfully mastering the classic strategies like overwriting and cash-secured put sales. As you build your record of success and experience, you can “paper trade” the more complicated strategies. Many brokerage firms have paper-trading laboratories so investors can hone their skills before committing money. Some investors will sneer at paper trading. They will think it is not a worthwhile use of their time. In reality, institutional investors rarely commit any real money to the market without paper trading. The institutions create models, and back test trades to see how they performed under different conditions. The primary reason for paper trading – the institutions call it modeling trades – is to reduce risk to maximize profits.

Of course, it is natural that after you master the bedrock strategies that we have detailed, that you will inevitably be drawn to more sophisticated approaches. You will want to combine puts and calls into strategies like the risk reversal. The strategy involves selling a put and buying a call with higher strike price but same expiration. The “risky” is used when investors think a stock might decline or advance. By selling the put, investors express a willingness to buy the stock at a lower price. The long call positions them to profit if the stock advances. The “risky” can be a great way to take advantage of investor fear ahead of earnings. Oftentimes, the amount of money received for selling a put is enough to cover the cost of the call. Sometimes, the trade even generates a credit.

Bull and bear spreads are also great ways to map out trading ranges for stocks. Spreads are limited loss, limited profit strategies.

A bull spread, or call spread, involves buying a call and selling another with a higher strike price but similar expiration.

Imagine Stock XYZ is at $50 and you wanted wager on a January earnings report. You could buy a January $52.50 call for a $1 and sell the January $57.50 call for $3. The spread would have an effective cost of $2, representing the difference between the long call and short call. If the stock is at $57.50 at expiration, the spread’s maximum profit is $5. In other words, investors have risked the $2 cost of the spread to make $5. Hedge funds tend to like call spreads because the returns often exceed 100% if everything works as expected.

With a put spread, or a bear spread, investors buy a put and sell another with a lower strike price, but similar expiration.

Imagine Stock XYZ is at $50 and you wanted wager that the stock will decline on a January earnings report. You could buy a January $52.50 put for a $1 and sell the January $47.50 call for $3. The spread would have an effective cost of $2, representing the difference between the long put and short put. If the stock is at $47.50 at expiration, the spread’s maximum profit of $5. In other words, investors have risked the $2 cost of the spread to make $5.

After some success using options to calibrate stocks, many investors become enticed with the idea of trading options for the sake of options. They will try to take advantage of discrepancies between realized and implied volatility, for example, or use strategies to isolate more esoteric measures, including “the Greeks,” that measure options sensitivities to change in volatility, the underlying stock price and interest rates. While there is certainly money to be made doing just that, most investors will do better just using options to better control stocks. Remember the KISS Principle, and use options to help realize the key objectives of investing.

Trading Rules

The options market is infamous for causing information overload. There is simply so much information to learn, and so many variables to analyze, that it is easy to suffer from “paralysis by analysis.” But if you remember a few key rules, you can give yourself a bit of an edge and tame some of the information.

  • Remember the Good Investor Rule coined by Steven M. Sears, Barron’s options columnist. Bad investors, Sears says, think of way to make money. Good investors think of way to not lose money. The subtle shift in thinking can change outcomes. If you are focused on investments and options strategies with well-defined risks, with outcomes that are understandable, you make better decisions. If you are constantly trying to make a ton of money as fast as possible, chances are you’re going to make some major mistakes, and suffer losses.
  • Paul Tudor Jones, a hedge fund manager, is legendary for having anticipated the great stock market crash in 1987. He has said that he believes most investors lose money because they are too focused on trying to make money. “They need to focus on the money they have at risk; how much is at risk in any single investment they have. If everyone spent 90% of their time on that rather than 90% of their time on pie-in-the-sky ideas about how much money they’re going to make, then they’d be incredibly successful investors,” Jones said.
  • Be wary of leverage. Each options contract represents 100 shares of stock. Never buy or sell more puts and calls than you can afford to cover. You might be able to sell 10 puts, but make sure you can cover 1,000 shares of stock. Many investors blow themselves up because they get drunk on leverage and let themselves be defined by risk, rather than defining risk with their options positions.
  • Don’t be greedy. If you double your money, take profits. A 100% return is a rare event, and it doesn't get much better than that. Yet, those kinds of returns tend to throw mental switches for most investors. They lose the ability to think because they feel so good about having made so much money. But the market is mercurial, and it always seems that a 100% gain angers the market gods. Stories are legion about investors making a big score, and then losing it al because something unexpected happened that knocked down the stock, or the stock market, or both.
  • If you do not take profits, sell half of your position. If you bought 10 calls, for example, and you are sitting on major profits because the underlying stock price has surged through the strike price, sell five calls and take a profit. The goal is to always play with house money. The options markets are profitably fueled by mistakes made by undisciplined traders who confuse a winning position with something like extraordinary investment acumen. Stay humble. Be paranoid, and don’t ever underestimate the power of luck. One very successful former CBOE trader has a tattoo on his arm to perpetually remind him of this. His tattoo says “I’d rather be lucky than smart.” The guy is very smart.
  • Time is your enemy and your friend in the options market. Options are wasting assets. They lose a little bit of value each day. The phenomenon is called time decay, or theta, and it is why many investors prefer to sell options against stocks that they own or want to buy. Some investors love time decay, and that’s why they sell options. Be clear of your intentions.
  • Expirations matter. Anytime that you are preparing to buy, or sell, an options contract, investigate all of the known events that are covered by the expiration. If you are buying a call that expires in three months, visit the company’s investor relations website. See when the company is reporting earnings, or presenting at a conference. Figure out if any major economic data will be released before expiration. Find out the same for major competitors. Do everything possible to make time work for you, not against you.
  • Do not fall in love with positions. The options market is a rental market. The stock market is a buyer’s market. Use options to rent stocks. If you realize your investment objective in a day, good for you. Move on. Odds are the returns do not get much better.

Investor, Educate Thyself

Options trading is as much a way of thinking as it is a way of investing. Veteran traders often have a common philosophy, or way of looking at the world. We’ve assembled a select reading list that captures the intellectual energy and philosophical framework of the options market. The information will expand upon what we have shared, and sharpen your thinking, too.

Our top resources for the options market:

  • Steven M. Sears is one of the most widely read authors on options and investing. His Barron’s column, the Striking Price, focuses on options trading. He is renowned for simplifying complex trading strategies and financial information so that anyone can understand. Many investors, ranging from those trying to learn about options to the options markets most sophisticated traders and strategists, read his column to learn about options trading and get investing ideas. His book, The Indomitable Investor: Why A Few Succeed in the Stock Market When Everyone Else Fails, explores why so many people struggle in the markets and provides a way for them to succeed. You can connect with him on Twitter sm_sears.
  • The Options Industry Council is an educational organization that was founded by the Options Clearing Corp and options exchanges. The OIC’s website, www.optionseducation.org, that is loaded with information on options strategies and terminologies. OIC offers free webinars and seminars. The information can be dry, but it is free of hyperbole, which is a rarity when discussing any financial subject. There’s no get rich quick promises at OIC, only solid education content on key strategies and concepts. Learn more at https://www.optionseducation.org.
  • Tom Sosnoff is one of the CBOE’s most successful alumni. He traded index options at the exchange, and then created an options-centric brokerage firm, thinkorswim, that was bought by TD Ameritrade. Sosnoff is now focused on www.tastytrade.com, an online financial network that each day produces eight hours of educational and other video programming that is focused on options and investing.
  • Successful investors are different than other people. They see the world in a different way. They buy when others sell, and sell when others buy. They often talk about themselves as contrarians. Humphrey B. Neill, the author of The Art of Contrary Thinking, is the father of contrarianism. His thinking figures heavily in successful investing, and especially options trading. Neill famously wrote: the public is often right during the trends, but wrong on both ends. Many seasoned options traders like to quote that phrase because is so perfectly captures the spirit of contrarianism while revealing a truth about markets. Neill’s book is filled with great insights, and it is a must read for anyone who wants to better understand the often counter-intuitive nature of successful investing.
  • The hardest decision most investors make is not determining what stock or fund to buy, but when to sell what they have bought. This is true when investors are looking at significant profits in a winning position, and it is doubly true when they are faced with losses. Most people cannot admit defeat in the markets, and they lose money hoping that the initial reason why they bought a stock ultimately proves true. Justin Mamis, a former NYSE trader, wrote a classic book that takes investors where few others have gone. His book, When to Sell: Inside Strategies for Stock Market Profits, offers keen insights into the discipline of selling. Almost no one ever discusses losses, or selling strategies, and that’s one reason why the book is a cult classic among institutional investors.
  • The financial markets are chaos. The market mob is often too greedy, or too afraid. This has been true throughout history, and it will never change. Trying to understand crowd psychology, and the movement of the mob, is thus a key requirement for successful investing. In 1841, Charles MacKay published Extraordinary Popular Delusions and the Madness of Crowds. He chronicled economic bubbles, and delved into alchemy, and all sorts of other crowd events that seem so incredible that it is stunning anyone could have been enticed by the idea. MacKay chronicled events like Tulipmania, an incredible investment bubble, when people in Holland bought tulip bulbs for more money than many houses cost. Almost 200 years have passed, and the book remains a valuable resource for investors. The market mob never dies so anyone who invests needs to understand the ageless dynamic that creates economic bubbles and also bursts them apart.
  • If you want to delve deeply into the mysteries of options, and you want to walk a path trod by many professional traders, check out Sheldon Natenberg’s Option Volatility and Pricing: Advanced Trading Strategies and Techniques. The book is not light reading, but the knowledge is worth the effort, and you will likely know more about volatility than almost anybody else you know or meet.
  • Lawrence G. McMillan was one of the first investment strategists to recognize that options could be used to help investors more effectively control stocks. He detailed his thinking in his book, Options as a Strategic Investment, that delves deeply into different options strategies. His book has since become an investment classic.

More Options Resources