The ABC’s of Successful Stock Option Trading
Short of having a crystal ball, picking winners when stock option trading is
not as hard as many people would have you believe. In the first place, when
considering purchasing or selling stock options, you need to conduct
extensive research on the underlying stock yourself, or rely on someone else
to do it for you – someone you trust. Many factors must be considered.
Among these are:
1. The stock’s past history and movement.
2. Expected earnings reports of the stock’s parent company.
3. Volatility and volume of shares traded daily.
4. Any current news concerning the company’s growth or profitability.
5. The price of the option with respect to how you think the stock will
perform. If you do not feel the stock’s movement will handily offset the
cost of the option, plus the trading fees, then buying or selling the option
would be fruitless.
6. Supply and demand of the underlying stock. (Industry group market
Once you have decided upon which stock to pick, you next need to decide
whether you believe the stock’s price is likely to rise or fall. (With
stock options you can make money in either direction.)
By purchasing a Call option:
1. You expect the price of the underlying stock to rise, so you can
then purchase it at the lower strike price, making a profit in the transaction.
2. You have the right to control 100 shares of stock for a fraction of
the cost of purchasing the stock outright.
3. You are managing your risk by limiting the downside to the premium
paid for the option. The major downside to buying any option is time decay.
Your option expires within a finite period of time. If the underlying stock
price behaves as expected, you will not need to be concerned about
Having shown you the benefits of buying Calls over the risks of
purchasing the stocks outright, we must emphasize the fact that buying
short-term Calls has its associated risks as well. A Call buyer, especially
a short-term Call buyer, is severely limited by the time-decay factor. The
nearer to the expiration of an option, the less the option is worth, and the
less time is remaining for the option to become profitable. Within the
leverage used by gambling casinos (the house), the concept of short-term
Call buying is completely understood, as well as exploited, as gamblers are
considered short-term Call buyers.
Example: Consider your long-term Put, or Call, as a 6 to 8 month license to operate a
casino. It allows you to capture short-term premiums; money that gamblers
continuously give to you in attempting to beat the odds by speculating they
will make profits on very risky bets. They feverishly feed the slot
machines, ante up at poker, double-down on blackjack, or spin the roulette
wheel. The odds are overwhelmingly against these short-term buyers. You, as
the casino owner, continuously capture these short-term premiums, easily
offsetting the expense of the license to operate the casino, then earning
substantial, clear profits in the following months. They know the odds are
with the casino owner, but they still take the enormous gamble on the slim
chance they will hit a jackpot. The lottery works in the same manner.
On one side of the position, the transaction is definitely gambling, while
on the other, the casino is simply engaging in business. Would you rather
bet on the remote chance of a gambler’s rare, limited success, or rake in
the steady, routine premiums captured from operating a successful business?
Yes, occasionally a gambler does beat the odds to enjoy a limited, windfall
return on his bet. For the casino owner, that is simply part of the cost of
doing business. But we all know where the true, long-term profits lie. 30%,
40%, 50% and more, are common, and in short periods of time. The odds are
with the short-term option seller, not the buyer.
When you choose a stock for short-term Call buying, you not only must
carefully consider the proper stock for the type of option you are
purchasing, you must also decide which direction the stock will move, then,
that movement must occur within a specified, very limited period of time.
Many investors have gone broke by attempting to make those same decisions.
In short, time is not on the side of the short-term option buyer. It is on
the side of the option seller.
1. Buying stocks is risky.
2. Buying short-term options is less risky, but still risky.
3. Selling short-term options is the least risky, especially with a hedge, or insurance.
By selling a Call option:
1. You expect the underlying stock price to fall, so the option will not be
exercised, but expire, worthless.
2. You can capture the entire premium that was paid to you, as profit. If the
underlying stock price rises, you are obligated to sell 100 shares of stock
at the lower strike price. If you do not already own those shares, you would then
have to buy them at a higher market value, then sell them at the strike price, in order
to meet your obligation. This situation is called a “Naked,” or “Uncovered” position, and
is extremely dangerous. Anytime you sell a Call option you should consider
buying the same option with a slightly lower strike price, and longer
expiration date. This will reduce your profit potential, but will also
reduce your risk considerably. (Remember the parallel twins, Risk and Reward
– If you want to reduce risk, you must also give up some degree of potential
rewards. You may wish to lower your cost basis in the stock, to the extent
of the premium received.
By purchasing a Put option:
1. You expect the price of the underlying stock to fall, allowing you
to sell stock at the higher strike price, and thereby earning a profit.
2. This option is also used in a combination strategy as a hedge
against selling Puts. We will explore that strategy later, in detail.
3. Buying Put options could also be used as a hedge, or insurance,
against the possibility of a price drop in stock you already own. Consider
You own 100 shares of ABC stock, and are concerned that the stock price
could suddenly fall. You purchase a Put option on the same stock, with a
strike price at current market value. If your stock falls in price, you
would have the right to exercise your option and sell 100 shares of ABC
stock at the higher strike price. The premium you paid for the option could
be far less than the loss you would have incurred without that insurance. In
this instance buying Puts acted as a hedge against the possibility of a
price decrease in the stocks you already own. If the price of the underlying
stock increases, your loss is limited to the premium you paid for the
option. The option acts as an insurance policy against possible loss.
Selling a Put option without an opposing hedge -“Naked”
You expect the price of the underlying stock to increase, causing the
Put option you sold to expire worthless. You can then capture the entire
premium paid to you, as profit. If the underlying stock price were to fall
below the strike price, then you would be obligated to purchase the stock at
the strike price, or pay the difference between the strike price and the
stock price, if you do not want to own the stock. Your upside is limited to
the premium received for selling the option. Your downside is potentially
unlimited to the base value of whatever you could sell the stock for on the
open market, or to the difference between the strike price and the stock
price. This is a “Naked,” or “Uncovered” position, and should never be
allowed to occur, unintentionally. Without the implementation of combination
strategies, the main objective of the Put seller is to hope the option
expires, allowing him to capture the entire option premium as profit.
Nearing expiration, if the stock price moves below the strike price,
changing the option’s value to ITM, and highly vulnerable to exercise, then
the option seller must move quickly to buy back the option, perhaps
lessening his profit potential, while also managing his risk. Even so, a
small loss would be better than having to buy 100 shares of stock at
inflated prices. Also, the loss can be immediately compensated for by
simultaneously selling another Put expiring in the following month. We use
OPM (Other People’s Money) to buffer downside risks, while buying more time
for the stock price to rise.
Stock Option Trading, when done properly, can drastically reduce, or even
eliminate, these two stumbling blocks to stock market success. In the first
place, A trader of stock options never is not required to own the underlying
stock in which an option is based. He or she can design a trade in such a
way that downside risk is limited to the cost of the option, which in itself
is a fraction of the cost of the stock. We capitalize on traders and
speculators greed to get rich who purchase overvalued short term options bid
up to inflated levels by an excess of demand over supply, by being the house
or casino owner and capturing the inflated premium from the players or
buyers. We buy reinsurance at a low cost by purchasing a longer term ( 5 to
6 months) out of the money option to sell the stock at a fixed price no
matter how low it may drop. We buy this reinsurance ( puts ) to create a
profitable hedge and sell overvalued puts repeatedly, month by month to
bring the cost of our hedge down to zero and a credit so that we can enjoy a
free ride capturing this inflated premium income. This strategy is known as
diagonal put spreads and you do not need to pick a winner to profit.