Buying and Selling Options without Getting Burned
From puts and calls to iron condors and butterflies, options strategies can be highly complex and the losses unlimited. Options trading is a hot topic these days, with some young traders making a killing on options on GameStop, AMC and other popular stocks. People are seeing that fast money can money can be made this way…if you do it right. On the flip side, the promise of big profits tempts many inexperienced traders who end up losing money at record speed.
While at times it may look that way, options trading is not easy. Then, there can be other obstacles out there in today’s market: the broker-dealers themselves. Upstart brokerage Robinhood made big news earlier in the year. FINRA, the financial industry regulator, leveled a record $70 million fine against it for not serving and protecting customers properly.
Part of the issue? It provided misleading information about options which led to customer losses. Also, it approved options trading for those who didn’t have the requisite experience to handle these fast-moving financial products.
One particularly tragic recent example was a young investor who committed suicide after Robinhood’s platform mistakenly showed he owed $730,000. According to the lawsuit papers filed by his family, in reality, he didn’t owe anything.
In the right hands, options can be a useful tool that can help you place controlled bets, manage risk and protect stock positions. But the learning curve is extremely steep. Losses and gains happen fast, and time can often work against you. That’s why options must be handled with care.
Here are some basics to help you gain awareness of what you need to know before you start.
First, let’s review the basics of options.
What is an option?
An option is a derivative, which means it is a financial instrument that derives its value based on the price of something else. In this instance, the cost of an option is derived from the price of the underlying stock.
There are two types of options: calls and puts.
What is a Call Option?
A call option gives you the right, but not the obligation, to buy shares of a stock at a targeted price on or before a specific date. The target price is known as the strike price.
For example, you could buy a call option on XYZ Corp. stock and pay for the right to buy the stock at $100 on or before Jan 15th. For that right, you’d pay a price.
Each option normally covers 100 shares, and the price is quoted per share. So if the option price shows $3.50 (which is referred to as the premium), you would need to multiply that premium by 100 to get the actual cost to you (plus add any commission or fees). So, in this case, you’d take $3.50 x 100 plus the commission (let’s say that’s $5). So you’d pay a total of $355 in this example. This enables you to control 100 shares of stock.
If the underlying stock price goes up, you can expect the option price to rise as well. However, it’s not necessarily a stable relationship. Along with the underlying stock price, an option price is also impacted by time and volatility. The more days you have left on the option, the more value it usually has. Then the option price can also be impacted by the volatility of the underlying stock. This is all quite complex, which is why there’s an entire field of study out there on options pricing theory.
That’s one reason that options are not as easy as they seem.
What is a Put Option?
A put option gives you the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price.
Put options are often used to protect your position in a stock. If you think the price of a stock you own will fall, you can hedge it by buying put options. Or you can speculate that a stock you don’t own will drop in price.
Buying or Selling Options
There are two ways to employ options. You can either be a buyer or a seller of a stock option.
Buying an Option: If you buy the option, you can speculate that the price will rise with a call option. Best case, the option increases in price, and you can sell it for a profit. If the trade doesn’t go your way, your maximum loss is the price you paid. And be prepared for that, as many options expire worthless.
Selling an Option. You can also take the other side of these trades and sell options. In that case, you are “writing” a contract, so you obligate yourself to buy or sell the stock at that strike price. You also get paid the premium, which you receive the minute you sell. However, your obligation remains until the option expires.
Selling options is an advanced strategy, so you must apply and meet certain net worth and experience requirements. However, not all brokers are strict about approving this feature, so you must tread carefully here.
How do You Sell Put Options?
One popular option selling strategy is selling a put. If you sell the put, you agree to buy the stock at the strike price. Now, this can be a way to lower your costs. You also immediately get to keep the premium, lowering your costs further.
However, put selling can also be dangerous since you’re legally obligated to buy the stock no matter what. If a market crash occurs or some unexpected news comes out, you’re still stuck buying the stock.
To do this conservatively, you can do a cash-secured put, meaning you keep enough cash in your account to cover the full purchase should it be required.
A significantly riskier strategy is selling naked puts. That means you sell the options, but you don’t have the cash sitting ready in the account. In this case, you may use margin if you have to buy the stock. This is where people can get into fast trouble, especially if the entire market drops.
How do you Sell Covered Calls?
Options are not inherently risky; they are simply tools. In some cases, options can be used for very conservative strategies. One such strategy is a covered call. A covered call is something that can help you hedge a stock holding as well as generate more income from it.
Here’s how it works. Let’s say you own 1,000 shares of Apple stock, but you don’t think the stock will go up much in the near future. You can sell covered calls against that stock, meaning you agree to sell the stock if it rises a certain percentage above its current price. You get paid a premium, but you’re also required to sell the stock if it rises (or you can also buy the option back).
If the stock goes up, you keep the premium, and you sell the stock higher.
If the stock drops or stays under the strike price, you simply keep the premium.
This can help you generate income from current stock holdings and lower your net cost of the stock, reducing your risk.
Understanding Options Spreads
From here, option strategies can get significantly more complex. Spreads, for example, offer a way to play the speculation side of the option but then limit your risk, so it’s not an all-or-nothing approach.
A spread is created by buying and selling an equal number of options on the same underlying stock but at different strike prices or expiration dates.
Iron Condor and Other Complex Stretagies
But that’s only the beginning. Many highly exotic options strategies can be quite elaborate to both create and unwind. To see how complex they can get, let’s look at one called the Iron Condor. With a name like that, we know it will not be simple, right?
This particular strategy is created by selling one call spread and one put spread with the same expiration date on the same stock.
These strategies do allow you to fine tune your risk. But here’s the problem: sometimes you need to unwind these trades, and if you don’t do it properly or in the right order, you can create problems for yourself. You can sometimes create a very brief point in time where you have a lot of liability.
This is one area where Robinhood’s customer display showed large negative balances that were transitory and caused many customers intense anxiety.
What’s the Difference between Stock and Options Trading?
Going in to any more detail is beyond the scope of one article. However, as you can probably see, there’s a whole lot of complexity with options. But aside from the complexity, what are the main differences between options and stock trading? Let’s boil it down:
- Options offer you a way to control more stock with less money.
- This gives you leverage. Leverage allows you to make money faster. But here’s the key: you can also lose money much more quickly.
- With stocks, as long as you’re not investing with leverage, you have the benefit of time. If the stock goes in the opposite direction you were expecting, you can usually wait for it to recover without losing anything.
- With options, that’s not the case. You are essentially buying and selling time. You have to be right within a specific time frame.
Consequently, options require much more precision and knowledge.
Final Words of Advice
Option trading can be a fast way for less experienced traders to lose money. Add the recent charges against broker-dealers like Robinhood and you have even more potential to get burned. Bottom line: invest in research first, so you don’t end up getting a much more expensive education than you bargained for.