From Trading Stocks to Trading Options

Balancing act As everyone knows, most investors continue to use stocks (as opposed to options) for their primary investment tool. Although options volume continues to grow each year, there are still a lot of people who do not understand what all the fuss is about. Well hopefully, I can give you a quick rundown of the reasons investors should be versed in both stock and options strategies. By “versed,” I mean educated in how options work and the potential benefits (and risks) they provide when used correctly. I do not mean, “just try and figure it out by making real trades without knowing what you are doing.”

In order to move along, I will skip the super-basics: What is a call? What is a put? What is expiration? etc. If you need to brush up on these mechanics go to The Options Industry Council. Here the option novice will find the information needed to understand this blog.

How Options Compare to Stocks:

1. The potential for increased return on investment by risking less capital.

Prices in examples given are as of Monday, June 14.

If you expect a stock to move within a defined time frame, you can buy in-the-money (ITM) options that would express this view but require less capital than buying the stock on margin. For example, if you think that Citigroup C is going to be trading as high as $5 by the middle of September, you have two choices:

A. Buy 1,000 shares of the stock at $3.90 for a total of $3,900 which you can margin (requiring you to post $1,950).

B. Alternately, you could buy 10 of the September three-strike calls for $1.01 per contract ($101 per lot, $1,010 for a 10-lot).

If the stock goes lower, you are at risk of losing up to 100 % of the initial investment in both scenarios.

2. Built-in stop loss.

What happens when a trade goes against you? If we look at our Citigroup example above, one thing options traders should do is select the strike to be purchased with a stop loss in mind. In the previous example, we know that our maximum loss with the options would be $1.01, or $1,010 on 10 contracts. Investors who owned the stock, however would have to enter a stop-loss order, or watch the position closely to make sure the loss did not exceed the target. In the previous example, investors would lose a maximum of $3,900 on the stock trade if Citigroup stock declined all the way to $0.

3. Strategies to consider for sideways markets.

Suppose you have a core group of stock holdings, but you become relatively indifferent to the market’s shorter-term prospects. With options, you have the ability to make trades that benefit from a neutral outlook. For example, if you own JPMorgan JPM stock you feel as if the shares are going to struggle to advance through the end of the year for whatever reason, you may choose to sell upside calls against the stock position. With the stock trading $38.05, you can currently sell the January 2011 40 calls for $3.70. That option premium is slightly under 10% of the value of the stock.

If you are right and the stock remains below $40 at January expiration, you will have collected $3.70 and the call will expire worthless. A couple of caveats: this does not prevent you from losing money if JPM stock were to suffer a large drop. You own the stock for $38.05 and you collect $3.7, but everywhere below the breakeven of $34.35 you lose money dollar-for-dollar with further declines in the stock. This covered call position could be an improvement tojust owning the stock, but not profitable. Also, if JPM stock rallies a lot in this time frame, you risk giving up the upside potential of straight long stock. If the stock finishes anywhere above $43.70, you would have been better off just owning the stock outright.

B. Even if you do not own JPM stock, but you believe it is not going to move much over the next few months, you could sell a JPM iron condor to collect premium. Sticking with the same example of January 2011 expiration, you could sell the $36/$33 strike put spread (selling the 36 strike and buying the 33 strike), and the $42/$45 (selling the 42 strike and buying the 45 strike) call spread. At the current prices, you would collect $1.01 for the put spread and $0.99 for the call spread. That means you would take in a combined $2 for a spread that can lose $1 at the most (the difference between the put or call strikes minus the total premium). If the stock finishes between your short strikes of $36 and $42, you would just keep the $2 credit as profit. The spread starts to be less profitable above $42 or below $36 in the stock. In order to put this trade on, you need to post $1 of capital. This is a strategy with some interesting risks if you end up near one of your strikes at expiration, as the investor may not know until the closing bell whether he will be assigned any shares or not. In these cases, it might be less stressful to close that side of the condor (or at least the near-the-money strike) on expiration day. Please make sure you understand the strategy completely before executing the trade.

4. Strategies that could profit or reduce risk in down markets

Put options can be used to express a negative view to the markets:

A. You can buy puts to hedge your long stock positions. This is another way to establish a stop loss on a long stock position. When you buy a put, for the timeframe before it expires, you are basically stopped out at the strike price less the premium you paid. (Puts give you the right to sell your long stock at the strike price.) If the stock does not finish below the strike, the puts you bought expire worthless and you lose the entire premium paid. One other note: if you purchase put hedges frequently, the total premiums you have to pay could equal a relatively high percentage of the stock price, which could make it difficult to remain profitable being long stock over time.

B. If you feel the market or a stock will trade lower, you can express this view by buying puts, buying put spreads, or selling call spreads without owning the stock. All of these strategies have a “negative delta,” meaning their prices will theoretically rise with a fall in the price of the underlying stock. These strategies provide alternatives to shorting stocks outright.

Again, the most important factor in trading options successfully is being thoroughly educated in the strategy prior to entering into a trade. We provide weekly trading webinars on Tuesdays, “Two Traders, One Strategy” which is found on the events tab on the OptionsHouse home page. Also, using a virtual trading account to try out new trades is a good way to try strategies without risking your real trading capital.

Best of luck in your trading!

Photo Credit: nugunslinger

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