Make no mistake, traders who deal in options have orders of magnitude more options – trading alternatives, to be clearer – than those who simply trade in stocks. But this these stock options strategies comes a price – the risk is also orders of magnitude greater.
Because with stock trading, if your approach is to get in and out quickly, your risk is usually a few points. With options on the same stock with the same movement, you may indeed be risking nearly everything.
Or, you stand to double or triple your money while the stock investor only makes a few bucks.
The reason for this is the leverage stock options provide.
Stock options are contracts to either buy (calls) or sell (puts) 100 shares of a stock at a given price (the strike price), and within a limited amount of time. The “buy” or “sell” action pertains to the option holder (the investor acquiring the contract), not the person who sells the option contract itself.
Which means, for the seller (writer) of the contract, the verbs are reversed: the original seller of the call contract will sell stock called away from them at a given price, and the original seller of a put contract agrees to buy the stock at the strike price.
The movement of the stock, in addition to the remaining time of the contract’s life, are the sole determinants of the option’s value.
Which means, if a $20 stock goes up three points over the course of a month, for a 15 percent gain, the call option is likely to double or triple in value. And that’s a 100 to 200 percent gain for the option holder. Same stock, same move, same timeframe.
But, with orders of magnitude greater risk.
Because the reverse is true, as well.
If that $20 stock goes down three points in a month, the option is likely to become nearly worthless. At least the stockholder still holds an asset worth $417 per share, while the option contract holder, if they didn’t get out in time, hold something worth pennies on the dollar.
The ways one can combine and manipulate call and puts options is wide and often complete. There are strategies called strips, straddles, spreads and writing regimens, all of which create a trade-off between protection from downside risk and the potential of the upside.
There is no such thing as a free lunch with options trading strategies, you have to give up something to gain something on the other end of the risk-reward continuum.
The Conservative Side of Strategy
Sometimes options trading strategies are actually on the conservative side. Stock owners can write (sell) options contracts against their holdings, generating immediate income that, in effect, lowers their cost basis and protects them to some degree to the downside. But, they forfeit potential profits if the stock goes higher than the sum of their investment basis, any increase before it reaches the strike price, and the proceeds of the sale itself.
Let’s look at an example. Let’s say you buy 100 shares of XYZ at $19. Then, you sell (write) a call contract against that stock at a strike price of $20, which means you must, if called, sell your stock at that price to the option holder. For that you receive $2 per share.
In effect, your cost basis is now $17 (your $19 cost, lowered by the $2 option premium received). If you sell the stock at any price above $17 you make, money, and you get to keep the $2, too.
Let’s say, though, that the stock goes to $24 by the end of the option period. Someone out there holds your call contract, and will be buying (calling) the stock from you at $20. That’s all you get, plus the $2 for option itself. You make a $1 profit from your original $17 cost, plus the $2 proceeds, for a total of a $3 gain. Even though you forfeit the $4 gain you’d have realized had you kept the stock without writing a contract and simply sold it at $24.
This trade-off is the variable of any stock options strategy. With this level of complexity, investors are advised to educate themselves before diving in. Because the guy on the other side of trade most certainly will have.
