How & When to Trade Options
Deep dive into options trading & strategies to utilize it to your advantage in both bull markets and bear markets
Dear Sunday Investors:
Welcome to this week’s edition of the Sunday Investor! To our new members, the format of this weekly newsletter will be a deep-dive into one investment-topic. This week’s article will be about options trading; first we will look into the basics of options, and more into a few of the most widely used options strategies, and then we will talk about platforms for both the stock market and cryptocurrencies where we are able to trade options using what we have learned!
Read, enjoy and share with any friends. Let’s build wealth together.
Weekly Market Recap
Let’s dig into some of the most important events that happened in the markets in the last week:
All markets are down: The S&P and Nasdaq suffered their worst week since the pandemic began, tumbling 5.7% and 7.55%, respectively. The cryptocurrency market is not faring well either with BTC down -16% and ETH -24% in the last week alone.
The yield on 10-year U.S. Treasury notes jumped to a 2-year high as investors brace for a more aggressive timeline on policy tightening by the Federal Reserve. Correlation with #1 why markets are down, I think so…
Federal Reservations About CBDCs. The United States Federal Reserve released a paper Thursday evaluating the idea of a Central Bank Digital Currency.
Microsoft purchased game publisher Activision Blizzard for $68.7 billion, in an effort to set "building blocks for the metaverse".
What Are Options?
According to Investopedia, options are contracts giving the owner the right to buy or sell an asset at a fixed price (called the “strike price”) for a specific period of time. That period of time could be as short as a day or as long as a couple of years, depending on the option. The seller of the option contract has the obligation to take the opposite side of the trade if and when the owner exercises the right to buy or sell the asset.
Popular Reasons People Trade Options:
To wager on the direction of a stock in the future (and can make money betting on if it goes either up, down, or neutral)
As a hedge against a declining stock market or individual stock
To generate recurring income
Risks of Options Trading:
Options trading can be very risky and are not suitable for every investor. When trading options with your broker (TD Ameritrade, Fidelity, Robinhood etc.), you will typically see a disclaimer similar to the following:
“Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry a substantial risk of loss.”
Now that we know more about the basics of what an option is, why investors trade options, and the potential risks of options, lets dig deeper into what we need to know before trading!
When trading options, the way they are quoted may seem a little bit different then when buying or selling an individual stock (ex. Buy 15 shares of GME) :
Instead, an example Gamestop stock option quote would read: GME January 28th, 2022 $110 Call at $7.25. To buy one contract here it would cost you $725.
Options Basics
As we talked about, when you buy an options contract, it grants you the right but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.
There are two different types of option contracts, a call option and a put option. A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Think of a call option as a down payment on a future purchase.
The major components of an option are:
Strike Price – The strike price is the price that you are allowed to buy the underlying stock
Premium – The price of the option that an individual would pay
Expiration Date – The expiry date when the option expires and is settled
Each option is known as a contract and each contract represents a claim of 100 shares of the underlying stock. Option prices are quoted in terms of per share price and not the total price that you may pay.
For example, Jim is planning to buy 1 option of Apple. The price is quoted at $2.50. His total premium to purchase one contract will cost $250. (100 shares x 1 contract * 2.50)
Call Options:
When you buy a call, it gives you the right (but not the obligation) to buy a specific stock at a specific price per share within a specific time frame. A good way to remember this is: you have the right to “call” the stock away from somebody.
If you sell a call, you have the obligation to sell the stock at a specific price per share within a specific time frame — that’s only if the call buyer decides to invoke their right to buy the stock at that price.
Buying A Call Option Example:
We will buy one call option contract on ABC stock with a strike price of $25. He pays $150 for the option. On the option’s expiration date, ABC stock shares are selling for $35. The buyer/holder of the option exercises his right to purchase 100 shares of ABC at $25 a share (the option’s strike price). He immediately sells the shares at the current market price of $35 per share.
We paid $2,500 for the 100 shares ($25 x 100) and sells the shares for $3,500 ($35 x 100). Our profit from the option is $1,000 ($3,500 – $2,500), minus the $150 premium paid for the option. The net profit, excluding transaction costs, is $850 ($1,000 – $150). That’s a very nice return on investment for just a $150 investment.
Put Options:
Put options are the opposite of call options. They give you the right but not the obligation to sell a stock at the strike price by the option’s expiration date. The value of put options increase as the price of the stock falls.
To purchase a put option, the buyer would pay the seller of the option a premium. At the expiry date, the option may be settled or expire worthless.
Buying A Put Option Example:
Now let’s buy a long put for Oracle (ORCL) stock that is currently trading at $45. If you think the stock will go down, you could buy a put "at the money" with a strike price of $45 per share for a $3 premium on 100 shares, set to expire in three months - making the cost of the contract $300 ($3 times 100 shares). Given the long put strategy, $300 is the max amount you can lose on the trade. If the stock falls to $35 per share by the time of the expiration date, you will be $10 "in the money" on your long put, making you a $700 profit on the option.
A Few Options Trading Strategies:
There are a variety of different options strategies that investors like us can use for specific situations; lets look at a few of the many below. If you want to dig deeper into options strategies, check out optionsplaybook.com for more!
Covered Calls
Covered calls are a powerful option strategy when you already own stock in a company, and want to both limit your downside while also thinking there will be neutral to slightly bullish sentiment in the stock.
Why/When to Use this?
-Limits downside risk when you think a stock will be neutral/slightly bullish
-Premium received from selling a covered call can be kept as income for the trader (great strategy for passive income)
Here's a hypothetical example of a covered call trade per Charles Schwab. Let's assume you:
Buy 1,000 shares of XYZ stock @ $72
Sell 10 XYZ Apr 75 calls @ $2
Because you bring in two points for the covered call, it provides two points of immediate downside protection. In other words, you will not have a loss unless the stock drops below $70.
But there's always a downside, and in this example the trade-off is that you limit the upside profit potential beyond a price of $77. So you would only want to do this if you think the price of XYZ will not exceed $77 by the April expiration. If XYZ does increase above $77, the stock purchase alone would have been more profitable.
While looking at the chart below, we can see:
The breakeven price is $70.
The profit is capped at $5,000 for all prices above $75, $3 x 1,000[shares stock] + $2 x 10[options contracts] x 100[options multiplier]The stock can drop two points before you go into the red. Losses will be incurred below $70 to zero.
Losses could be as much as $70,000 if the stock price drops to zero, but they will always be $2,000 less than the stock trade alone.
Bull Call Spread
A long call spread’s goal is to profit from a gradual rise in the stock, just like a regular call option. With a long call spread, your initial risk is less, but because this is the case, your potential profit is also less when compared to just buying a call option.
Why/When to Use this?
-Limits your total downside risk as it is a cheaper initial investment than just buying a call option
-This is a strategy you use when you think a stock will be be bullish or go up
An options trader believes that XYZ stock trading at $42 is going to rally soon and enters a bull call spread by buying a JUL 40 call for $300 and selling a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200.
The stock price of XYZ begins to rise and closes at $46 on expiration date. Both options expire in-the-money with the JUL 40 call having an intrinsic value of $600 and the JUL 45 call having an intrinsic value of $100. This means that the spread is now worth $500 at expiration. Since the trader had a debit of $200 when he bought the spread, his net profit is $300.
If the price of XYZ had declined to $38 instead, both options expire worthless. The trader will lose his entire investment of $200, which is also his maximum possible loss.
There is much more we can dig into here, but these give us a good start on a few popular options strategies. More on this here if you are interested. Now that we have options basics, lets go into where we can trade options!
Where To Trade Options?
Options trading is available on virtually every trading platform. Here are a few examples of trading platforms that offer options trading. One thing to keep in note is that there is typically a disclosure you have to submit before you are “approved” to trade options on your account because of the increased risks.
TD Ameritrade - Best overall options trading platform and tools
E*TRADE - Best web-based options trading platform
Robinhood - Best for beginners
What Does It Cost?
Unlike trading stocks which are all zero-commission on all of these platforms, options trading requires a small fee every time a contract is bought. On all of these platforms above, the fee per contract to trade options is $0.65. Not the end of the world, but definitely something to keep in mind.
Bonus: Options Trading For Crypto?
So now that we discussed what options are and a few strategies that we can use for stocks lets look at how we can transfer this new knowledge to another asset class, cryptocurrencies.
Enter Ribbon Finance. Ribbon uses financial engineering to create structured products that deliver sustainable yield. Ribbon's first product focuses on yield through automated options strategies but also allows developers to create structured products through combining various DeFi derivatives (like covered calls).
To deposit in the Covered Calls Vault, all you have to is connect your ETH wallet such as Metamask and relax as the vault earns yield on its ETH deposits by running a weekly automated ETH covered call strategy. The vault reinvests the yield earned back into the strategy, effectively compounding the yields for depositors over time.
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Not financial or tax advice. The content in this newsletter is for informational purposes only. Every investment and trading move involves risk. Do your own research when making a decision.