I have been sitting on the sidelines of option trading for a while, researching the subject and educating myself and seeing how best to use this as a medium to generate additional passive income to facilitate my dividend portfolio. I have finally decided to take the plunge after crafting a strategy that would be ideal for my situation.
There is a LOT of information out on the interweb explaining the basic terms of option trading. Unfortunately, while most of these instructions explain the basics well, they do not do a great job of elaborating the risks where such trades could go wrong. For the beginner atleast, this discussion starts to get too complicated far too quickly. In general, stock trading when not understood correctly can be a recipe for disaster. But when it comes to options, that risk is multiplied by a sizeable factor.
So what the heck is an “option”?
The textbook definition of an option is this: it is a contract that gives the buyer of the contract the opportunity to buy or sell an underlying asset at a predetermined price within a certain period of time.
There are several terms and concepts here that warrant further clarification.
- What is an underlying asset? In our case, stocks for a particular company.
- Since the contract is valid for only a certain period of time, each contract is associated with an expiration date.
- The predetermined price for the contract is typically called as the strike price.
- Notice that the definition says “gives the buyer the opportunity…”. So the buyer can choose to NOT buy the underlying asset, if the current stock price is not conducive to the trade. More on this in a second.
- An option contract is typically defined in terms of 100s of shares i.e. 1 contract = 100 shares.
There are typically two types of options that are available for trade:
- Call Option: This option gives the buyer an opportunity to buy an underlying asset at a strike price before expiration date.
- Put Option: This option gives the buyer an opportunity to sell an underlying asset at a strike price before expiration date.
Call Options – Better Explained
Call options can be better understood using the following example. Consider that you are looking to a buy a house. You find a house that you like, you like its listed price and you decide to enter into a contract with the seller by providing a specific down payment (a specific non-refundable percentage of the list price). The down-payment made as a part of this contract now provides you an opportunity to buy the house at a predetermined price before the contract expires (lets assume the contract was valid for a month). During this contract period, one of two scenarios is likely to happen: you will eventually buy the house after the contract expires OR you will back out of the contract and not decide to buy the house for whatever reason. For instance, you, the buyer find out that the house has some structural issues in the foundation and you decide that you do NOT want to purchase this house anymore. You back-out of the contract. The seller gets to keep the down-payment portion. On the flip side, if you are happy with the house and the contract period expires, you will eventually buy the house at the agreed upon price and you now own the house.
The call option is very similar to the above example. The down-payment, in this case, is what is commonly referred to as the option premium. If the buyer of the option contract notices that the price of the underlying asset (i.e. the current stock price) has increased beyond the strike price, the buyer can exercise the option and buy the shares. Why? Because he is now getting those shares at a cheaper price through this contract than what the market has to offer. However, if the stock price happens to remain below the strike price during the contract period, the buyer would never exercise the option (after all why would he want to pay a higher price for the stock if he can buy it cheaper at the market price). In this case, the option contract expires worthless. The seller of the call option contract gets to keep the premium regardless of what happens with the option contract. If the first scenario plays out, the contract is said to be In-The-Money (aka ITM) i.e. the value of the stock per the option contract is below the current market value of the stock. If the second scenario plays out, the contract is said to be Out-of-the-Money (aka OTM) i.e. the value of the stock per the option contract is above the current market value of the stock.
Put Options – Better Explained
A Put option can be better understood using the following analogy/example. Lets assume you own a share of Apple (ticker: AAPL). Lets assume the stock is currently trading at $170. Due to some recent news and your own research, you have reason to believe that AAPL’s iPhone production is going to be severely impacted in the next few years that would cause a huge dent in their earnings. You are expecting the stock price to tank shortly. You would like to “buy some insurance” such that if such an event were to happen within the next month, you would be able to sell the company at a predetermined price, say $150, and walk away, thus minimizing your overall loss.
In essence, the “insurance” you are buying is the put option contract. As a part of buying the insurance, you are paying a premium to the seller thus giving you the opportunity to sell the shares of this company if the stock tanks. If the stock were to drop below your predetermined strike price ($150 from the above example) before the expiration data, you get to exercise the contract and sell your shares at higher price compared to the market value of the share (ITM). If, on the other hand, the stock never tanks below $150, you will never sell your shares and the contract would expire worthless (OTM). In either case, the seller gets to keep the premium for providing you this “insurance”.
Time is a huge factor in determining the option premium for any option contract. And based on time, there are some option metrics/parameters that investors can use to determine the risks associated with any given option contract. These are typically denoted using greek alphabets and are popularly referred to as “Option Greeks”. There is a LOT that can be said about each of these, but I’ll focus on the salient ones:
- Delta: is the rate of change of the option’s price for every $1 change in the underlying asset’s stock price. A quick use of this parameter is to determine the probability of the option contract will expire ITM.
- Theta: This represents the amount by which the option’s price would decrease as the time to expiration approaches.
- Gamma: represents the rate of change of delta w.r.t changes in the underlying asset’s stock price.
- Sigma: Or more commonly referred to as “Implied Volatility” (IV), in addition to delta, is perhaps one of the most important Greeks for option traders to examine. This represents a probabilistic estimation of the market’s forecast of the movement in the underlying asset’s stock price. It can also be viewed as a gauge to estimating market risk. A higher sigma/IV would typically result in a higher option premium.
Option trading for the beginner
If you are reached this far and are still with me, please pat yourself on the back! You are now armed with a basic understanding of options. At this point there are several interesting paths forward.
In my case, my next step was to determine how to use this knowledge and make it fit into my overall investment goals. There are several strategies available to option traders, some more complicated than the others, and suitable to different investment styles. Two of the these strategies that are especially popular amongst beginners and that seemed to resonate with me were: covered calls and cash-secured puts.
I arrived at the following conclusions w.r.t these strategies and option trading in general:
- As a beginner, it is far easier to sell options. Let me elaborate on this through the next two bullet items.
- If you own atleast 100 shares of a particular security, selling covered call options is a great strategy if you are okay with selling a stock at a price where you believe the stock is overvalued. Why? Well, you believe that the stock is overvalued at a specific price based on your research and you are okay with selling the stock at that price. As opposed to selling x100 shares through your broker through a regular stock trade, by using a covered call strategy to wait for a your desired sell price, you get paid an option premium for waiting. If the option expires worthless, you continue to hold your 100 shares and earn a premium.
- If you want to own atleast 100 shares of a particular security at a specific price, and you have some cash available to you, enough to cover the cost of 100 shares * specified price, selling cash-secured puts options is an ideal strategy in such a situation. Why? You are interested in opening a position in a particular security, but what the market is offering you is more expensive than your desired buy price. So you wait. But waiting as a part of a cash-secured put option strategy allows you to earn a premium. If the stock price drops and reaches your target buy price, you get assigned these 100 shares. If the stock price does NOT drop and the option expires worthless, you get to keep the premium and, potentially, re-open another option contract to repeat the same.
- In general, we want the choose a strategy such that the option contract expires worthless most of the time i.e. OTM. Why? This reduces our risk profile in that we essentially get paid for waiting (either for the stock to drop to our reasonable buy price OR stock price to reach a desirable sell price) without actually going through a trade of the underlying asset.
Note: In the above conclusions, I have avoided option margins altogether i.e. I am ensuring that all the collateral required for the option contract are coming from me and there is no reliance on my broker.
Trading, in general, is serious business and you can lose money if you are not sure what you are doing. Option trading is no different, the stakes are a lot higher if anything. Therefore, it is worth highlighting the risks associated with such trading:
- Call option: In the event the option gets assigned and the stock shoots to the moon, you would be missing out on capital gains that you would have otherwise been entitled to if you had held onto the stock. So you have to absolutely certain about the underlying fundamentals of the business. If you don’t do so, you run the risk of selling a multi-bagger stock.
- Put option: In the event the option gets assigned and the stock tanks to hit rock bottom, due to something fundamentally wrong with the underlying business. In such an event, you would be holding onto stocks that could potentially be worthless.
Beyond these, I have also come to realize that I would never consider selling covered calls on most of my dividend stocks. Why? Because if the option were to get assigned, the resulting stock sell would put an immediate halt to several years of dividend compounding and hurt my original yield-on-cost. The option premium + capital gains I would make as a part of the stock sell trade would not compensate for that. This is perhaps the biggest risk of option trading in my case, so I have to be incredibly careful in choosing which stocks to employ this strategy with.
There is a LOT more to research and understand in this subject, but hopefully this gives you an ideal launchpad into this area. As always, please do your own due diligence and see how this fits into your own investments. The idea here is to keep your…options…open 🙂
Discl: Long AAPL