One of 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:
- 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.
- A strike price – This is the price of the underlying stock that will be used to understand what happens to the option contract
- An underlying – Can be a stock or an index or whatever really (also currencies)
- 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.
- 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.
- 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)
- If you sell CALLS you need to have the stock in your portfolio or cash enough to cover the eventual assignment.
- 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.