Options for Dummies

One IMG_20140516_210603of the fellow bloggers that I admire a lot (DIY UK) asked me in a recent post if I could provide a sort of “guide” to options… As I am a total newbie I will not venture into the complex systems that I have been studying over the past few months, but I’ll try to give an idea of how options work for me as simple as possible.

First of all: do your own research and study! There are a lot of sites that provide great help and information, do check them out before venturing into option trades.

To my understanding options are pretty much like insurance covers, you get to pay or get paid against a certain occurrence.

An option is made of:

  1. An expiry date –  This is when the option contract ends. There is no life for the contract after that. On the last day of trading the contract is “resolved” and certain effects happen.
  2. A strike price – This is the price of the underlying stock that will be used to understand what happens to the option contract
  3. An underlying – Can be a stock or an index or whatever really (also currencies)
  4.  A premium – This is what you get paid or have to pay when “signing the contract”.

How do I get paid:

You get paid only when you SELL a PUT or a CALL option. By selling the put and calls you promise (in exchange for money) that:

Put: You will buy the underlying at the strike price, IF at the expiry date the price of the underlying is EQUAL or LESS than the strike.

Call: You will sell the underlying at the strike price, IF at the expiry date the price of the underlying is EQUAL or GREATER than the strike.

On the opposite side, you can BUY a PUT or a CALL and in that case you will have to pay that premium. By paying the premium you get to:

Put: Decide if you want to sell the underlying at the strike price, IF at the expiry date the price of the underlying is lower or equal to the strike price.

Call: Decide if you want to buy the underlying at strike price, IF at the expiry date the price of the underlying is higher or equal than the strike price.

Be careful:

  1. You must have cash in hand (I don’t like to trade uncovered), because if your strategy forces you to buy the stocks you need to have the money or the broker will liquidate your assets.
  2. There are minimums, it’s not like you can sell options for 10 shares. Normally minimums are 100 pieces, sometimes are 500 or 1000 like in the UK. This is important because if you decide to sell PUTs like I do it would be better to have that amount in cash to cover for a potential assignment. (see point 1)
  3. If you sell CALLS you need to have the stock in your portfolio or cash enough to cover the eventual assignment.
  4. The higher a stock has been volatile, the higher are going to be premiums. This is good if you have an entry point in mind and really believe that that stock is going to do better in the future. This is why I rarely trade options on stock on which I did little research…

How do I trade (so far)? I am using options to:

Try to enter is a position at a price that I want consider right.

Let’s say that I have a target price on Generali of 10 Euro. The stock has been hovering between 10 and 12 for the last 3 months. If I sell a put for this stock (Generali is one of the few positions that allow 100 pieces trade in Italy), I am committing to buy the 100 pieces at 10 euro (total 1000 euro), at the expiry date if the price is 10 euro or lower.

Clearly my risk here is that if the price goes to 9 euro I will lose 100 euro in this said trade at the expiry date of the option. The fact is that if I had bought the stock at the price that I wanted on the day that I wrote the option I would be at loss anyways so in reality, as I want to own the security and I want it for my dividend strategy the assignment of the stock is not a huge tragedy.

If the price stays above 10 euro I do not get into the position that I wanted, but I keep the premium.

Try to profit from the stocks that I have when prices are higher than my average cost.

I do not have a lot of cases here yet, because my portfolio is up, but I do not have the minimums required to trade. But let’s consider for example MMB (Lagardere). I have it at an average price of 22 euro, and I sold a call at 23 Euro that will expire on the 19th of August. If the price is met (or goes above) I am forced to sell the stock, but I will make a profit of 1 euro from the sale plus the premium that I have got when traded the contract. If the price doesn’t go above that mark I get to keep the premium. When I traded this option MMB was around 18 euros, so quite far from 23, today is 22 something, so probably the option will expire worthless and I will keep the money, but it’s important to see that stocks can rally 20% in 45 days…

Tactical use on European stocks.

This is a new system to me, but there are a bunch of stocks that I’d like to add, but price is quite far from the desired entry level (10%++) and most importantly, they pay dividend only once an year… If I managed to enter today at the right price I’d be keeping money waiting to get the fist dividend maybe in 6 or 7 months… What I do, I sell a put at the desired entry point, at a date 1 month before ex-dividend date. I then look at it, if the price skyrocket and the option value decreases I might consider to close the trade early, otherwise I take it till expiration, actually hoping to be assigned (as I’d love to collect that dividend!!).

There are traders like Chris and ATL, who are very experienced and trade options close to the actual price (the option jargon calls the actual price “money”, so the trade is close to the “money”). This means that you can get much higher premiums but also the chances of being assigned rises.

As to me I am keeping quite far from the money as most of the positions that I open are done to get a certain entry point, so in a high market like now there aren’t many opportunities… Calculating the trades done so far and annualising them (provided that I can keep on track with this style all through the year), so far I’d be looking at a return of almost 7% on the capital deployed… Before you go thinking that this is a lot, consider that some traders can do 45%/50% on their efforts…

But I am happy like that, at least to start with I think it’s ok and it serves really as an optimisation of my portfolio and the cash that I am not deploying since there are little opportunities out there…

Hope that the explanation was simple enough, options are much more complex than this, so I really suggest you do the research needed, I have taken away all the maths, all the rules and graphs that are part of understanding a derivative instrument such as this.

 

 

 

 

 

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14 thoughts on “Options for Dummies

  1. Ciao Stal,

    Really good guide. I have learned quite a bit than I did 10 mins ago. I still think I’ll stick with DGI investing for now, but maybe in the future 🙂

    Who do you know what options are out there to be accepted or not?

    Tristan

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    1. Ciao Tristan,
      This is a point that I did not wrote about, thanks for bringing it up! Actually you “bid” for an option, there is a spread that is indicated but that changes while the stock price change. When selling a PUT for example, let’s say that you have a 0.5/0.8 spread, if you place your bid at 0.8 it’s likely to get executed only if the stock moves down during the day, or if a fellow seller is willing to give you that money for the contract. I first calculate my minimum desired rate of return, then I place my moves. As I am trading “far from the money” in many cases, there are lots of bids that don’t get executed. When my real money is maxed out on the options that I have bought I stop. I could go on buying on margin, but I do not feel confident about it… Thanks for coming and hope it makes sense! 🙂
      ciaociao
      Stal

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    1. Ciao ATL,
      Still early stages, but it’s moving… I have to remind myself NOT to be greedy, and yet I was not assigned any stock to start the “sell calls” part of the story. But I am not complaining, learning as I go by I guess… 🙂
      ciao ciao
      Stal

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      1. That is the best way to learn. And from the mistakes of others. My July and august were big mistakes months.. learned a lot on myself and some more complex products. A post in preparation.

        Like

  2. I’d be interested in reading that post then! Complex products limit gains and risks (Iron condors, jade lizards and so on), but so far I haven’t found a practical use, probably because I am going after strikes that are too far from the money and gains would be squeezed… Anyways I’ll wait for the post I guess… 🙂
    ciao ciao
    Stal

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  3. Stal,

    Many thanks for the introduction to options – very interesting.

    I have heard about the options before, I think some of my investment trusts use them to boost income but I did not understand how they worked so thank you for taking the time to explain.

    Am I correct in thinking the main benefit to operating this for of strategy would be mainly for those that hold individual shares – the PUT option could be taken out on shares I already own and the CALL option would be useful in relation to shares I may be interested in acquiring for my portfolio.

    Could be a win/win situation as you are effectively hedging your bets and gaining profits on stocks you already own or want to own.

    If I have understood this point correctly then, for myself, as I have decided to wind down my individual shares and focus more on index funds such as the Vanguard Lifestrategy, maybe this options approach may not be such a good route for me to pursue.

    Many thanks for the detailed post and explaining how you go about the process and I am sure it will be of interest to many of your readers.

    Good luck with this and I hope it continues to add to your returns…I would be happy with an extra 7%!

    Like

  4. Ciao DIY,
    Thanks for the comments, glad that it helped a little!

    Going to your questions, when SELLING options contracts (aka. shorting puts/calls): a PUT contract will get you stocks assigned (in the UK minimums are 1000 stocks of whatever you are trading, not all the stocks can have options contract written), CALL contracts will get your existing stocks sold (you have to won 1000 shares in order to have a so called “covered call”, otherwise you must buy at the price of the day and give them away).

    Yes, in a way it’s a sort of hedging, especially when (like you are doing), you are trying to sell positions to move to funds.

    Provided that the stocks that you own are enough to short calls (sell call contracts), and provided that the stock is “optionable” AND provided that you find an interesting strike, you can make profits from owning the stocks and if the calls are “hit” you will sell at a price that you are happy with.

    Let’s say that you still own Unilever (actually I think you sold it…), and let’s say you have an average price of 20 GBP, and you have 1000 pieces, you could sell a call for 33 pounds (it’s about 31GBP now), get a premium and see what happens. If it gets called away you have the profit that you wanted, if not sell again after expiration and start over.

    On the other side since you are going for less active approach (funds) Options might not be your cup of tea, but they can be used to put to work some capital that otherwise is sitting on the sidelines waiting for dividends to mature.

    My extra 7% will be hit ONLY if I keep trading like this for the whole year, if I stop tomorrow the return will be around 1% I guess… 🙂 And there will be mistakes and bad trades, so losses are there to strike at any time, and as these are derivatives losses are normally big… In my case losses are contracts getting assigned, and since I do not trade if I don’t have cash down I need to sell the stocks before I can continue, effectively reducing the returns over time…

    Thanks for stopping by and giving me the chance to write the article, it was good for me too! 🙂

    Ciao ciao
    Stal

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  5. Ciao Stal,

    Awesome blog post! I think it can not be written to often how options really work.
    Everyday a few more readers look at our blogs, and they have no idea of trading options.
    Thanks for sharing ! Thanks for mentioning my blog!

    I think in the next year we all take it to the next level 🙂 I am sure.
    At the moment I am working on a good capital base for my options trading. Trying to beat the 2000 € / month at the first time in the next few months.

    We are all learning from each other. So, i love it to read every new blog post from option traders 🙂
    thank you!

    best regards
    Chri

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  6. Ciao Chris,
    No worries, you are much more experience than me and I really look up to that 2000 euro a MONTH of trading proceedings… Wow! Yes I agree that writing about option trading helps the community and also ourselves in understanding better this instrument, there are people out there that make a lot of money through trading options but I feel that they work on mathematical models too, still it’s an interesting system to keep the money from being idle.
    ciao ciao and keep up the great work!
    Stal

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  7. Great post. A lot of bloggers reach out to me and ask me for advice on how to sell options. I point them in the direction of a few books that resonated with me. But, I think the best way is to learn by actually trading. Interactive Brokers (IB) has a great paper trading UI. If an investor wants a risk free way to test options, I suggest IB.

    Like

    1. Totally right IH, Interactive Brokers offers the option of a paper account to make some sample trades, but I have used it to learn about the operative parts of trading options, when I started to put “real money” in the system the feeling was totally different, but surely it was a great help to know how the platform behaves. I haven’t read books so fa, might have to get onto them because I feel that my trading system can be improved…
      Thanks for commenting!
      ciao ciao

      Stal

      Like

  8. This is a very helpful post, thanks a lot. I see I was getting mixed up with selling a put and a call option. I guess if you hold a dividend paying stock you can make more income by doing a call option? Something I need to look into a bit more.

    Like

  9. Ciao Tawcan,
    Yes technically you can boost income selling calls, practically you need 100 pieces of whatever you want to sell and to be honest with you all my core stocks are too high in price for me to even dream to hold that much… PLUS be careful because you might actually end up having to sell a core dividend stock if the call gets “in the money”. What I am learning now is that options NEED to be managed… Much more than simple dividend stocks…

    Like

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