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Options 101

Options trading has become very popular since the start of the pandemic and it’s easy to understand why—every day thousands of people score incredibly big wins, often with very low cash outlays.  YOLO baby!

But there are risks.  The biggest being the simple fact that most options expire worthless.  Zip.  Zero.  A 100% loss.  This begs the question:  Why BUY options when you can SELL them?

In this article – and our upcoming ‘Options 102’ story – we’re going to show you how to make low-risk, high-probability returns month after month by doing just that – SELLING options.

When you subscribe to our service, In The Money, we’ll do much of the work for you, sharing a new options trade every month.  Each trade will include a company overview, explain the mechanics of the trade and our expected returns, and even provide alternative strategies to tailor the monthly trade for your individual risk tolerance.

Willing to take on some risk to try to score a 10% return this month?  We’ve got you.  Seeking low risk, reliable single-digit annual returns?  We’re here for you…  Looking to YOLO?  Well…   ummm…  Two out of three.

Just like the regular stock market, not every trade will work—but our strategy can make you a winner, even if the stock behind the trade goes against us 5%-10% (or more)! (Yes, with our strategy you can be right even if you’re wrong!)

Our plan is to do all the thinking—but in the next two stories, we’ll give you a basic understanding of what options are, how they work and our strategy to maximize returns and minimize risk.

YOU HAVE MANY OPTIONS IN YOUR LIFE

Chances are you’ve owned an option on something — even if you’ve never had a brokerage account:  There are options in real estate purchases, options built into auto leases, options in many rental agreements.  Heck, if you are old enough, you or your parents may have had an option to purchase a television built into a ‘Rent-to-Own’ agreement.  (Yes, TV’s were once that expensive!)

In the most basic terms, options are agreements which give the holder the right – but not the obligation – to buy or sell something at a pre-determined price.  When you lease a car, for example, the lease agreement contains a clause granting you the option to buy the vehicle on or before a certain date (the lease expiration) at a certain price.

Purchasing a stock option is very similar:  You pay a small premium to receive the option to buy or sell a stock at a certain price sometime in the future (usually a month, but sometimes a week, a day or even a year later).  Such options are available on almost any widely-traded US-listed stock.

If you choose to exercise an option – whether on a stock, a car lease or even a ‘rent to own’ agreement – it’s said that you take delivery on the option contract and you purchase the asset covered by the options contract at the pre-determined price.

LESS CAPITAL AT RISK, MORE POTENTIAL REWARD

Let’s assume you are bullish on META-NASD (that’s the trading symbol for Facebook) and think the shares—let’s say they are currently trading for $170—are going to $200.

You could certainly buy the shares at $170 – putting up as little as $71 per share if you have a margin account – or, for a lot less capital, you could buy call options on META shares, giving you the right – but not the obligation – to buy those shares at a pre-determined price.

In this example, you may want to buy ‘at-the-money’ call options – or options granting the right to purchase (or ‘call away’) META shares at roughly the current price ($170).  This agreed-upon purchase price is called the strike price of the options contract.  Every options contract has a strike price.

Of course, the option isn’t free – after all, META could (theoretically) open at $200 tomorrow and you would still have the ability to ‘exercise’ your options and ‘call away’ – or buy – shares at the $170 ‘strike price.’  That kind of return potential is clearly worth something.

While there is an accepted formula to calculate options prices – named after the Noble prize-winning mathematicians behind it (Fisher Black, Robert Merton and Myron Scholes – or more commonly ‘Black-Scholes) the market ultimately decides the ‘premium’ – or price – of each option.  The market price of an options contract is largely based on past volatility, anticipated news events (such as earnings releases or dividends) and the amount of time remaining in the life of the option, or the duration.

TIME IS MONEY…sorta

Every option has a limited duration; an expiration date – it doesn’t matter if it is an auto lease, a ‘rent-to-own’ agreement on an apartment, or a call option to buy META shares.  If you’ve bought an option, you often dread the expiration date.  But if you sell an option, the expiration often represents the day you pocket the non-refundable premium received for selling the contract, making expirations good.

In the case of stock options, the common expirations are weekly (on Fridays) and monthly (always on the third Friday of each month).  The less common are three times per week (Monday, Wednesday and Friday), month end (the last trading day of the month) and leap options – which are generally one or two years in duration, expiring the third Friday in January.  All U.S. stock options expire at the close of trading on the last day of the contract – usually 4:00 EST.

Not surprisingly, the length of the options agreement – or the expiration – has a BIG impact on the price:  The longer the duration of the agreement, the more expensive the option will be – but less so that you would imagine.

In the case of META, a call option with a $170 strike expiring at the end of the next trading day is trading for $1.30 while a contract with six market days until expiration (the following Friday) is trading at $3.60, or $.60 per day.  If we look at the same $170 strike price for call options expiring four weeks (and a day) from now, they are trading at a midpoint of $7.82 – or $.37 per day.

CALL UPS & PUT DOWNS

There are also PUT options, which are basically backwards call options:  The holder of a ‘put’ contract has the right, but not the obligation, to SELL an asset at a pre-determined price for a pre-determined period of time.

If you were bearish on META and you purchased $170 strike put contracts, you could – at any time up until expiration – sell shares at $170.  It wouldn’t matter if META was trading at $200 or $50, you have the right to sell at $170.  This right goes up in value if the shares move lower:  The right to sell META shares at $170 is worth a lot more when META is trading at $140 than when it is trading at $160.

ONE IS A HUNDRED

Just a few more quick concepts and you will have graduated.  The first is that options contracts are traded in 100 share lots.  If you are buying META $170 strike call options expiring tomorrow, the quoted price is $1.30 – which is the price of the options per META share.  This means the minimum tradable size for META $170.00 calls would be $130 – or 100 X $1.30.  These lots of 100 shares are considered oneoptions contract.

NAKED IS RISKY AND COVERED IS SAFER

The next concept – one that is key to our newsletter ‘In the Money’ strategies – is that with the right account type (a margin account approved for advanced options trading), you can be the seller of options.

You can sell them naked – meaning you write call or put contracts on shares you don’t own (or aren’t short) – or you can write covered calls or puts, which are options contracts on shares you DO own (or ARE short in the case of puts) in your account.

For example, while you COULD just sell META $170.00 calls expiring tomorrow and be naked, but you would need to have the ability (the capital) to ‘deliver’ (or sell) 100 shares of META to the call option buyer.  This is a $17,000 transaction.

If you can’t (or don’t want to) deliver the META shares covered by the call option contract you sold, you would likely ‘buy back’ the options contract right before expiration (most brokerages make you do this at least 30 to 60 minutes prior to the close on expiration date).  This can be expensive, however, as market makers are pretty good at predicting when these forced transactions are coming and they adjust options prices accordingly.

The safer way of selling options – doing so on a covered basis – involves first buying the shares (to sell calls) or shorting them (to sell puts), THEN selling the options contract (most brokerages let you do both in one transaction).

In our META example, if we purchase 100 META shares, we can then write (or sell) one contract of covered calls at any strike price we choose and for any expiration time frame we choose.  (Yes, owning the underlying stock is like having clothes on, and not owning the stock is like being naked).

The trade is ‘covered’ and the broker won’t ever ask for more collateral because the person buying the call option would simply ‘call away’ – or take – the shares we already own.

In the case of puts, because the buyer of the put contract can basically force you to purchase shares at the strike price, you have to be short the shares.  If you are ‘forced’ to buy shares at the strike price, your brokerage will simply close out your short position.

Why are you forced?  Remember, the buyer of an option – call or put – has the right, but not the obligation to exercise the option and make a transaction happen.  This means that the seller (you in this example) has given away this right and thus has an obligation to do as the buyer chooses. In our next article, ‘In The Money’ options strategies, we will talk about our bread-and-butter strategy–covered call and covered put options.  We will show you how investors can profit from writing options—which are almost certain to result in the shares being taken away by the option holder.

Nathan Weiss & Keith Schaefer
Co-Founders, In The Money options trading service
Questions or comments? Reach out to us by email at: help@inthemoney.capital

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