Trading options is nothing like trading stocks. Most investors make the mistake of bringing their experiences and ideas about stock investing into the field of options. They view options as a leverage investment on a given stock or ETF and nothing else. Whatever direction the market moves decides the fate of your trade. This might be the case when trading stocks, but it doesn’t have to be with options.
Options traders do not view the markets as binary (long or short). Rather, an options trader makes an assumption based on his view of the market. He determines how bullish or bearish he is and applies the options strategy that best serves his assumption. Once the options trader chooses an appropriate options strategy he has the ability to choose a specific probability of success and the risk tolerance of his choice for each and every trade.
You simply can’t craft such specific and effective investment theses in stock trading. Stock traders do not have the ability to be partially correct and still make exceptional returns. But, that’s the whole point of using options effectively: putting yourself in the position to make money, even if you’re only partially correct in your assumptions.
Investing in options can allow you to make money on the randomness of the market – bullish, bearish or neutral, it doesn’t matter – as long as you give yourself a margin of error.
I realize this might be a foreign concept to some of you, but I will show you how the aforementioned concept is applied in the strategies below. Of course, there are risks and tradeoffs associated with options, but it’s a mistake to see any asset class as being non-risky.
I am confident that once you learn how to properly use options, you will immediately find that options are the most powerful tool in the investment arena and are a necessity to outperforming the market.I will go over the risks associated with each type of trade that occurs in my options strategies because it is just important to understand your risk as it is your reward.
There are only two types of options – calls and puts. It’s really very simple.The textbook definition of an option
is as follows:"The right, but not the obligation, to buy or sell a specified asset at a predetermined price over a predetermined time."
While the aforementioned definition is correct, it makes my eyes glaze over each and every time I read it.My goal is to bring options to the forefront, to dispel the mystery of how they are used and to show you how to use options in an effective and responsible manner. Definitions, like the standard one mentioned above only make options more difficult for the average investor.Simply stated, options can be bought or sold. An investor who buys an option is long the option. A person who sells an option is short the option. Simple, right?
There are only two types of options: calls and puts.Every position that is built using options is composed of either all calls, all puts, or a combination of the two. One thing that smart option traders know is that you can sell options as easily as you buy them. By learning how to incorporate both the buying and selling of options you will be learning the key strategies used heavily by most professional options traders.
So what exactly are call and put options?Both puts and calls can be either bought or sold, just like stocks. When you “buy to open” an option, thereby paying a debit, you are said to be long that option.When you “sell to open” an option, thereby collecting a credit, you are said to be short that option.
Buy a call (long call)Buying a call option – call option buyers hope for higher prices.The buyer of a call option has the expectation that the underlying security is going to move up. And when I say “underlying security,” I am referring to the stock, ETF or commodity in which you are trading options. In our case, ETFs. A call buyer has the right to control a bullish directional position of long 100 shares of stock per options contract for a specified time (until options expiration) at a certain strike price.The call buyer essentially pays a fee to the option seller for this right, which is called the “premium.” I will discuss premium shortly.
The following are the characteristics of a long call:
- Market sentiment – bullish
- Risk – varies, but has a limited loss potential equal to the price paid for the call option, otherwise known as the premium
- Time in trade – can vary from hours to several years (I typically hold a long call for less than one week)
- Winning trade – the underlying ETF advances in value greater than the amount of time value you paid for the option
- Losing trade – ETF remains stable or declines. If the ETF remains stable you will gradually lose time-value which will cause the price of the option to decline. If the ETF declines you will lose intrinsic value and time value will decline the longer you hold the trade, which will cause the price of the call option to decline.
Buy a put (long put)
- Buying a put option – put option buyers hope for lower prices.
Buying put options is the exact opposite of buying calls. The put option buyer has the expectation that the underlying security is going to move lower in price. A put buyer has the right to control a bearish directional position of short 100 shares of stock for a specified period of time at a certain strike price level. The put option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential.Just like call buyers, the put buyer essentially pays a fee to the option seller for this right, which is called the “premium.”
The following are the characteristics of a long put:
- Market sentiment – bearish
- Risk – varies, but has a limited loss potential equal to the price paid for the put option, otherwise known as the premium
- Time in trade – can vary from hours to several years (I typically hold a long put for less than one week)
- Winning trade – the underlying ETF declines in value greater than the amount of time value you paid for the option
- Losing trade – ETF remains stable or advances. If the ETF remains stable you will gradually lose time value which will cause the price of the option to decline. If the ETF advances you will lose intrinsic value and time value will decline the longer you hold the trade which will cause the price of the put option to decline.
Now that you know how to buy calls and puts, let’s move to something a little more complex, but certainly not difficult.The sellers of calls and puts have different views and obligations. Options traders sell options to bring in income.The seller of a call has a neutral to bearish view of the underlying security (although I take a different stance, which I will discuss in a future special report).
The seller of a put option has a neutral to bullish view of the underlying security (again, I will discuss how my strategy of selling options works in a future special report).
I do not sell calls or puts by themselves, otherwise known as selling naked calls or naked puts. I sell what is called vertical call spreads and vertical put spreads for reasons I will discuss in my Options Advantage strategy report.
So, simply stated:Sell a call (short call)
- Call option sellers hope for stable or declining prices.
Sell a put (short put)
- Put option sellers hope for stable or advancing prices
So let’s review.
- Buy calls (debit) = long calls = bullish on the market
- Buy puts (debit) = long puts = bearish on market
- Sell calls (credit) = short calls = slightly bearish to neutral view
- Sell puts (credit) = short puts = slightly bullish to neutral view
Again, I will go over the risks associated with each type of trade that occurs in my options strategies. Because it is just important to understand your risk as it is your reward.I am confident that once you learn how to properly use options, you will immediately find that options are the most powerful tool in the investment arena and are a necessity to outperforming the market.
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