Introduction - Understanding Stocks vs. Options

Stock trading allows traders to speculate on the directional movement of a stock. When compared to trading options, trading stocks is simpler but limited. Entering a stock position allows for exposure on the stock in both directions, meaning that you will have dollar for dollar exposure on both the upside and the downside. Using options to gain exposure on a stock is more complex, but with the additional complexity comes more flexibility. Options allow for exposure with direction, magnitude and timing unlike stock trading that only allows for exposure on direction:

• Direction - Buying and Selling a Call or a Put
• Magnitude - Options allow traders to gain exposure on how much a stock will move by selecting different strike prices
• Timing - Selection of expiration dates allow for bets on where the stock will move before a certain date

One of the main differences between stock and options trading is the risk profile. Trading stocks allows for a symmetric risk profile - dollar for dollar exposure in either direction. On the other hand, options have an asymmetric risk profile - potential for unlimited profits while risk is limited. Because options offer protection from downside risks, a premium is paid by the buyer of an options contract. 

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Calls and Puts

A call (put) option is a contract that allows the buyer of the option to buy (sell) stock at a certain price (strike price) on or before a certain date (expiration date). Each contract represents 100 shares of the stock. Before buying or selling options, there are a few terms that one should know:

• Current price - this is the price that the stock is currently trading at
• Strike price - the price at which the option contract can be exercised
• Expiration date - the date at which the contract expires 

When trading options a trader can do 4 actions:

1. Buying a call option (bullish) - This involves buying a call option contract and paying a premium. Buying calls is usually done when the trader has a bullish view on the stock. The strike price of the contract should be close to the current market price (In-the-money). For example - $XYZ stock is currently trading at $100 per share. The trader expects this price to move up and buys a $98 November call option for a $5 premium (per share). The premium is immediately given to the option seller. This gives the trader the right, but not the obligation to buy the stock at $98 per share during the life of the contract. If the trader was correct and $XYZ rallies to $110 per share, the call option allows the trader to purchase the shares for $98 and then he/she can sell the shares at the current market price of $110 resulting in a profit of $12 per share. However, the premium paid should also be accounted for. Therefore, the actual profit of this trade is $7 per share. If $XYZ were to be trading below $98 at expiry, the trader would choose not to buy the stock at $98 and lose a maximum of $500 ($5 premium x 100 shares). 
   
   Maximum gain = unlimited
   Maximum loss = $500 (premium paid)
   Breakeven price = $103 (Strike price + premium)

2. Selling a call option (bearish) - Selling a call option is used to generate income through the premium received by the option buyer. They can also be used to sell stock that is already owned at a higher price. This is called selling Covered Calls and is a very popular strategy used by investors to generate income while selling stock for a profit. Covered calls will be explained in further detail later in this post. Traders that sell call options have a bearish sentiment on the stock. The option seller usually chooses an expiration that much higher from the current market price to reduce the likelihood of the contract being exercised. It is important to note that the further away (Out-of-the-Money) the strike price is from the current price, the less premium will be received by the option seller. For example - $XYZ is currently trading at $100. The trader expects the price to remain neutral or move down and sells a $110 November call option for $5 per share. The seller will immediately receive $500 ($5 x 100 shares) and will only have to sell the shares if the contract is exercised (if $XYZ trades above $110 before expiration). 

3. Buying a put option (bearish) - Buying a put option gives the trader the right but not the obligation to sell the stock at a predetermined price (strike price). This strategy is used when there is a bearish sentiment on the stock. Therefore, the buyer of the put option will start to profit as the current price of the stock moves down. Like buying a call option, the strike price selected should be "in-the-money". For example - $XYZ stock is currently trading at $100. The trader buys a $102 November put option for $5 per share. This trade is profitable when the current price of $XYZ moves below $97 (strike - premium). The maximum loss is the premium paid of $5 per share. 
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4. Selling a put option (bullish) - Like selling a call option, selling a put option allows the seller to generate an immediate income from the premium paid by the buyer of the contract. The strike price should be "Out-of-the-money". If the contract is exercised, the seller has the obligation to buy the shares at a predetermined price (strike price) to the option buyer. In other words, selling a put option means that you are selling someone the right, but not the obligation to make you buy the shares at the strike price from the option buyer.

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Basic Strategies

Options can be used for both income and speculative purposes. In the above examples, selling options is used to generate income in the form of a premium received while entering long (buying) options are used for speculation as this allows for a directional bet on a stock. The most popular income strategy is known as covered calls. 

There are two steps required for an investor to execute this strategy – owning a minimum of 100 shares of a stock and shorting (selling) an “out of the money” call option. This income strategy is effective when there is a neutral or bearish sentiment on a stock. As the investor is the seller of the option contract, he/she receives an immediate income in the form of the premium paid by the buyer of the contract. Repeating this strategy generates a consistent yield while still owning the underlying stock. Here are some best practices for selling covered calls:

• The strike price should be above the current price. Use conservative strikes (15-20 delta)
• Sell short term options (3-7 weeks) as they have an advantage over long term contracts by avoiding earnings cycles and maximize time decay (theta)

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The Covered Call strategy also has another use - selling the stock at an appreciated price. For example - a trader that already owns 100 $ABC stock that was bought at $90 per share can write covered calls with a strike price that he/she would want to sell their stock for. If the trader believes that $110 would be the right price to sell $ABC stock, he/she can write covered calls until this happens. This allows the trader to generate income through selling covered calls, and if the target price is not reached before expiration, simply keep the shares and write another covered call until $ABC reaches $110. This makes Covered Calls a powerful strategy because the trader has generated an income through the premium received while selling the stock at a higher price. The one limitation to this strategy is that it can also limit profit potential if the price rallies sharply past $110. 

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Understanding the Greeks

The Greeks are used to measure the different factors that can affect the price of an option. At first glance, the Greeks can be intimidating to new option traders. Buying a stock allows for dollar to dollar exposure, however, options do not. While they are not as complicated as they may initially seem, it is important for traders to understand how the Greeks work at a conceptual level at least. The 2 most used Greek terms are “Delta” and “Theta”:

• Delta – Delta refers to the change in the option price with respect to the change in the underlying stock price. For example, buying a call option with a delta of 0.5 means that the value of the contract will increase by 50 cents if the stock moves $1 higher. Delta is calculated as follows:

• Theta – Theta refers to the change in the option price with respect to time. As options have an expiration date, options will decay in price as time goes by. Theta tells us the rate at which an options price will decay with time. When buying options, it is best practice to get in and out of the trade as quickly as possible to minimize the effect of time decay eating away at your profits. Theta is calculated as follows

Summary

Buying either a call or put option allows for investors to gain exposure to the directional move of a stock while placing a cap on the risk. Selling a call or put option is usually used as an income generating strategy as the seller of the contract will receive the premium immediately irrespective of where the stock price will move during the life of the contract. Here are some best practices to consider when trading options:

• Buying a call or put (Speculation):some text
  • "In-the-money" strike prices
  • Close the trade prior to expiration to minimize time decay
  • Use expirations 1 or 2 months out
• Selling a call or put (Income):some text
  • "Out-of-the-money" strike prices
  • Use short expirations to maximize time decay 
  • Avoid earnings announcements

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