[toc] Whether you’re just starting out with options or a more seasoned amateur, if you want to master this often-misunderstood investment strategy – you’ll have to get the basics right. This guide should help you achieve that. By learning to understand and trade options, you’ll not only add a lifetime skill to your investing education, but also gain insight into how the ultra rich build their wealth and copy their strategies.
Why Trade Options?
Options are ideal for providing insurance to your stocks, protecting profits, generating income and most importantly earning outsized gains. And if you suffer from some form of ADHD, then dig this – you can do all that in a shorter time frame of days, rather than months or years!
Market (& Risk) Friendly
Whether the market is moving up, down or sideways – you can use options to work in all markets – in short – you can make money in any market. You can soften the fall or even make money in a down (bear) market, outperform the market as it rises upwards (bull) and even generate income in a flat or sideways market. While this should not replace your traditional investing and trading – use it as a way to boost your performance, who knows… you might make it a habit!
Trade options not as a speculator but as an investor. That means that you don’t just jump in and out of a position, there’s some research to find out fundamentally strong companies – that have a good chance of generating returns for you. By doing this, you’re leveraging your knowledge of the company to boost the returns. You could just as well buy the stock, but it would take longer to generate the kind of results you’re looking for.
When you buy or sell options, your profit is usually unlimited. You can often make between 50% and 100% gains in a matter of weeks, sometimes days. This is why so many are interested in options trading (hint: you’re reading this!). Whilst it may sound too good to be true, there’s a downside to it. Just know for now that the reason you can make so much money with options trading is because of ‘financial leverage’. This is a financial phrase – that just means taking a small amount of money and multiplying it into a larger sum. The multiplying factor is the ‘leverage’. Because each option ‘contract’ represents 100 shares of the company, an investor or trader can control and benefit from that many shares without risking too much capital. A small move in the underlying stock of the company can create a big move in the option contract. In short, investors often buy call options rather than the stock outright to obtain leverage and potentially boost their returns, whilst limiting potential losses.
Did you know…?
Options were created as a form of insurance – yes, insurance. Just like you have insurance for your car, house, and other assets – a few people wondered why we couldn’t have insurance for ‘stocks’ – it is in any case an asset right?! And so that how options were born… do you know any particular investor who built his wealth with insurance? Keep reading, you’ll find out below! The first options were used in Greece in 300 BC – by an olive speculator. The Chicago Board Options Exchange (CBOE) was instrumental in allowing options to be traded in its current form and we have to thank them for this opportunity!
But what about the common man? What about the person who dreams of wealth… everyday? As Dave Ramsey put it, “If you do what rich people do, you will become rich, if you do what poor people do, you’ll become poor”. It’s that’s simple. Rich and Ultra-Rich people understand options trading… and take advantage of these tools for asset protection and accelerated wealth generation.
It’s not uncommon to make 40% – 50% returns, but you can also lose up to 100% if you’re not familiar with the strategies shared below. This is what they don’t teach you in business school! Don’t worry, it’s ok to be a bit skeptical – the proof is in the pudding and you’ll soon see how you can develop this skill very soon.
So is option trading risky? Hell, yeah. But the rewards are well worth the risk. You can and dare say – will lose money, but fear not – you can maximize those profits and minimize those losses. If risk is holding you back from making money, seriously, stop reading and do something better. Ok, excited? Still reading… let’s get started.
What Are Options?
An option is a standardized contract that allows you to buy and sell a certain amount (typically 100 units) of an underlying stock at a specific price for a specific time.
What are options?
Ok, there’s a difference between stock ‘shares’ and stock ‘options’. With shares you get to own a piece or percentage of the company. As long as you own it, you have a “share” in the company, like any shareholder or owner.
With options, you get a contract and like all contracts, there are two parties involved – a buyer and a seller. The underlying agreement is attached to a specific company’s shares. Each contract let’s you control 100 shares. The value of the contract varies… that’s what we call the option price. This is what accelerates your returns, because you’re not controlling just 1 share, but 100 shares – there’s the ‘leverage’ we were talking about. When the share’s price moves 1%, the option’s price can have a move of 10%.
A stock option is basically an agreement or ‘contract’ where one party agrees to deliver something (in this case stock ‘shares’) to another person within a specific period of time, for a specific price. So what we’re doing when we trade options, is basically trade these stock option ‘contracts’.
How do they work?
Let’s take an example of how this works. Remember, all we’re going to talk about is buying and selling contracts – because you got options, baby! (Sorry, that was bad humor).
Imagine you’re a real estate investor (a buyer), and you’ve found a nice house that is worth $75,000. You approach the seller, strike a deal with him and enter into an agreement with him by signing a contract… to buy the house within the next 3 years (because you don’t have the cash right now) at $75,000 – no matter what the price could be in the future (the price could go up, but it could also go down). In short, you get a ‘hold’ on the house.
In order to enter this agreement (contract) – you’ll have to make a down deposit that’s not refundable but can be set off against the price when you purchase the house. Some call this earnest money – let’s say $5,000 as good faith deposit (premium).
There could be many reasons why the seller would agree, but let’s just say for now… he’s not sure whether he will get more than $75,000 within the next 3 years. So he agrees. (He could be thinking that the market is going to crash or he may not have any more buyers as he’s rejected quite a few already, whatever the reason). In anycase, he’s going to get the good faith deposit, in addition to the price of the house – whether or not it sells.
Fast forward one year, a shopping mall and a school come up nearby – suddenly the price of the house is now worth $100,000. Remember, you have a contract that allows you to buy that house for $75,000 cash, even though it’s worth $100,000. That’s a good 25% discount if you exercise that contract. Think, just for a second…
You could sell that house the very next day of your purchase, for $100,000 and book a profit! But you would need to cough up $75,000 cash to buy the house. That along with the original down payment you made, means you would require $80,000. But you’d make a return of 20% ($100K / $80K) – not bad eh.
(If you’re really wiley, you could just sign a new agreement with another person take $100,000 from him and make the payment to the original seller and pocket $25,000. But this is a bit more riskier because asking prices are different from actual selling prices in the real world and requires more effort and time… in either case, the contract was your leverage.)
You could do something even better. Just sell the contract you wrote up for $10,000 to someone else (remember you put down a good faith deposit of $5,000) – that’s a 100% return on your money ($10,000 / $5,000).
Why would someone else buy that contract only? Well, he sees there’s another two years left in the contract and he believes the prices could go up again soon – he’s happy to buy, because there’s more potential value in it for him! This is in essence options trading… we sold the contract for a better return on our money. The contract (which allows you to have a ‘hold’ on the house) is your ‘leverage’.
Think for a second which is easier – the drama and paper work of transferring a house or just sending the paper contract! The value is not so much in the house, but the contract – because of the potential value it holds in two years.
So instead of risking $80,000 to make $100,000 (buying and selling shares) – you’re willing to risk $5,000 to make $10,000 (buying and selling options). Greater the profits, minus the drama and hassle. It’s the same game, played on a different level. So rather than buy the house (stock) outright, you can choose to buy contracts (options) on it instead – and that too far cheaper!
Basic Option Trading Terminology
Ok, now that you understand… how options work and why trade them i.e. basically buying and selling contracts that give you the certain ‘rights’, let’s dive in. There are basically two types of options:
- Put Options (simply called ‘puts’)
- Call Options (simply called ‘calls’)
A PUT option (contract) is used to protect the value of your assets, as well as make money when a stock falls in price. A PUT option gives you the right to sell 100 shares at a fixed (strike) price. Technically, a PUT option gives the buyer the right, but not the obligation, to sell shares of a stock at a specified price on or before a future date.
So let’s rewind a bit here… something for you to read, repeat and remember:
A put option will increase in value when the underlying stock it’s attached to falls in price, and it decreases in value when the underlying stock it’s attached to goes rises in price.
Have you got your head around that? No, read that sentence again. Counterintuitive maybe, but that’s the essence of it. Imagine you owned a stock and the current market price was for $30 (when you bought it for $40) – would you love to have an agreement that says you could sell it for $50? Bet you would… that’s what a put option is.
A CALL option (contract) is used to make a multiple of your money, when a stock rises in price. A CALL option gives you the right to buy 100 shares at a fixed (strike) price. Technically, a CALL option gives the buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a future date.
Remember that options are for a specific price i.e. the strike (exercise) price and for a specific period i.e the future (expiration) date. When we say we “exercise” the option, we’re basically referring to the contract owner acting upon the agreement.
There are five components of an option contract:
- Underlying Security – options are based on an underlying security – in this case the stock of a company that is listed on an exchange. So if the price of a stock rises and falls, the price of the option will do the same – there’s a direct relationship. This is where we get the term ‘derivative’ from because options are derived from an underlying stock. Keep in mind however, that not all stocks have options because of their low price or lack of volume and not all derivatives are stocks because derivatives can be for stocks or exchange traded funds (‘ETF’s) for precious metals, currency or the index.
- Right, Not Obligation – when you own the option (contract) you will get the right, but not the obligation, to buy or sell the underlying stock at a specified price on or before a future date.
- Price: Specified (Strike) Price – there are various strike prices for a stock option, giving you plenty of choices. Fortunately, this has been standardized – so you won’t see every cent being listed. You’ll probably see prices in increments of $0.50, $1.00 or $5.00.
- Time: Specified (Expiry) Date – whatever right you receive from owning the option – will expire on a given date, in the future. This is basically the life of the option, and after that future given date, the option ceases to exist even when the stock continues to. In technical terms, we explain this with the financial phrase, ‘Time Value of Money’ and with the passage of time as you come closer to the expiry date, the option value decays – we call this time decay. The more time you have to expiry, generally, the more expensive the option will be. And as time goes by, the option value starts to go down. This is unlike stocks, which do not have an expiry – you can own them for as long as you like, without worrying about a decline in value because of the expiry.
- Option (Premium) Price – this is basically the price of the option contract and listed in the “Bid”, “Ask”, and “Last Price” with your brokerage.
What are the four main factors that affect an option?
- Current Market Price – This is the current price of the stock quoted on the exchange every day. As the current market price changes, the option price adjusts automatically.
- Strike Price – This is the actual price at which the option will be exercised (assigned) upon expiry.
- Volatility – This is a critical part of the option contract, some stocks are more volatile than others.
- Time Remaining (Expiry) – The longer the time frame, the more expensive the option contract – because that gives the stock more time to play out its direction. Time can be both an advantage or disadvantage for the trader and investor (if you’re a seller, time can be your friend but if you’re a buyer, time can be your foe). You’ve probably heard of ‘Time Value of Money’ which simply means Time = Money!
Who are the main option market players?
There are basically four types of participants – 1) Call Buyers, 2) Call Sellers, 3) Put Buyers and 4) Put Sellers. Those who buy options are referred to as Option Holders (Owners) with a ‘long’ position and those sell the options are referred to as Option Writers with a ‘short’ position. Don’t worry about ‘long’ and ‘short’ – they are terms hardly anyone uses anymore (it’s confusing anyways).
The following table is worth a second and third glance, it summarizes everything you need to know (of course, as always all options are at a certain price and certain date):
Take note of the right vs. obligation? Ok, then. Just remember that call options are the opposite of put options – that’s all.
How to read an options chain (table)?
Before you start your first trade, you need to learn how to read an ‘options chain’ or as some call it an ‘option table’. An options chain is basically a list of all available option contracts for a given stock and their different expiration dates, so you can choose. And because there are basically two different types of options – puts and calls – an option chain will list all the put option contracts and call option contracts available for a particular stock along with all the expiration dates – which are in monthly or weekly increments, so you’ll have various combinations presented as ‘option codes’.
Given the number of stocks listed on an exchange and various possible prices of a stock as well as the various possible expiry dates, there are over 1 million option codes to choose from.
For example, whilst there can only be one price at a point in time for stocks, option contracts can have multiple prices expiring in various time frames… you can buy an option contract for a share at $30 strike price, or at $40 strike price or at $50 strike price and to make things more complex, you can buy for October, November or December or any month. But only a few are barely worth your attention.
Your goal should be to create a shortlist of 30 stocks to watch and trade regularly (remember, this is a beginners guide, so if you really want to get some action – then you’ll have to check out my advanced course for more).
No one has really figured out a way to simplify how options chains are presented – graphs don’t cut it – so you’re left with a dry table. And the problem starts when you look at various financial websites or online brokerages – each displays them with different layouts, even though the content is basically the same.
In any case, the options table or chain will be divided into two parts – with calls on one side and puts on the other side (see the following screenshot). However, there are some common elements across the board and they are:
The above shows the call and put options that expire on 21 August, 2015 which is the third Friday of the corresponding month. You may also notice that the also have weekly options, which is also on a Friday – but you don’t require that for now.
Symbol – lists the trading symbol to identify each stock option contract available. There is a specific coding format which is followed to identify the stock, the strike price, the month it will expire and if it is a call or put option. You really don’t need to know this, as your brokerage will make it easy to buy and sell options without the code – but here’s an example: AAPL150821C117 which simply follows the format:
Strike Price – this lists all the available strike (exercise) prices at which the stock can be bought or sold when the option is exercised.
Change – this lists the change in the options price. It shows how much the option price has risen or fallen since the previous day’s close – in absolute and/or percentage terms.
Volume – lists how many stock option contracts were traded throughout the day.
Open Interest – this lists the total number of option contracts still outstanding. These contracts have not been exercised, closed, or expired. The higher the open interest, the easier it will be to buy and sell the stock option because it means there are a large number of traders trading this.
Expiry Month – here’s where you see differences in the layouts. Depending on the month you want, there are options created by the market makers for you. Sometimes, you may not see each and every month.
Bid (Price) – is the highest price that a buyer is willing to pay for a particular stock option contract. This is the price other buyers are ‘offering’. The market is basically like an auction, there are various bids (offers) made by willing buyers who want that particular item. (When you sell an option, this is the price you’ll receive for the stock option). Once you own an option, the only number you’re interested in is the bid. The less you pay, the better.
Ask (Price) – is the lowest price that a seller is willing to accept or receive for a particular stock option contract. This is the price other sellers are ‘asking’. This is where you can see the various offers being made to the market for the stock option.
Last (Price) – this lists the last price at which the option contract was traded. It’s the last transaction price. This price could have been a few minutes ago, days or weeks ago – you never know.
Remember, in the case of bid, ask and last – it is just for the price of one share, when you buy or sell the contract (which is a basket of 100 shares) – you need to multiply this price by 100.
Bid/Ask Spread: The difference between the bid price and the ask price is what we simply call the spread. Pay attention to the bid, as that is what market makers (those who create the market for traders) manipulate to profit the most. Often, beginner (or rookies or amateur or newbie, call them what you will) traders jump in and pay the last price traded i.e. the market price, and make a loss before they’ve even started.
No wonder 90% of options lose money… well, here’s how you can beat the market makers and get the right price! In our example above with Apple (APPL) stock, you’ll notice for the 119 call option, the bid is 2.38 and the ask is 2.42, which gives a spread of 0.04. If you were a beginner, you’d jump right in and place an order for 2.38. And because the last traded price was 2.35, you’d be down immediately by 1.2%. If the spread was higher (which happens for not so active stocks) – this difference could be as large as 15%. So…
ALWAYS Use Limit Orders: You can place trades between the bid and ask, in 5 cent increments. This way you can pressurize the market maker to alter the price and reduce the spread. This will require a little patience (yes, that’s a virtue), but you’ll get a better deal. Even the 5 cent difference can really affect your returns in a big way because you’re buying in buckets of 100 shares. Let’s take the same example…
You would instead place a bid at 2.35 or 2.30 and wait. Yes, patience is a virtue. At least, you’ll start off on a good footing. This has its drawbacks, for not so active stock option and usually ones with a larger spread, the best option would be to take the average between the bid and the ask. So in our example with AAPL, you would bid 2.40 – and this would surely be executed.
How Do I Trade Stock Options?
WHY: When you believe the stock will rise significantly over time and you want to leverage your returns, or you want to minimize invested capital at risk – you buy a CALL option contract.
Investors or traders often buy call options rather than stocks, when they want to leverage and potentially enhance their returns significantly whilst at the same time cap the loss to what is being invested i.e. the maximum you can lose, is the option price (premium) you paid for each contract – which is usually smaller than what you would have paid for the outright purchase of the stock. That’s because each contract represents 100 shares that an investor or trader can control and benefit from.
For example, imagine a stock that you know well, that has been hit hard recently and now trades at $30. You have strong reason to believe that is was oversold, and that it will rebound and trade back at $50 in the coming months or year.
The market offers $35 call option contract that expires in nine months for a price (premium) of $1.5 per share. Since each contract represents 100 shares – that’s $150 per contract. If you take 10 contracts, that’s equivalent to owning 1,000 shares – the premium (price) would be $1,500 (plus your brokerage commissions). This contract if purchased, would give you the owner of the contract, the right to buy 1,000 shares of the stock at $35 any time before expiration.
If the price of the share, rose to $40 in a few months – your option contract will increase in value too, perhaps double to $3 or more per share. That means you could make 100% in just a few months, as compared to 16% if you simply bought the stock.
Catch 22: What’s the catch? There isn’t – but there’s a possible downside. Imagine the stock price continued its decline (for whatever reason) for a few months and your option contract would decrease in value, perhaps to $0.25 per share. After nine months, the price is now at $20, your option contract would expire worthless. You’ve heard the phrase 90% of all options expire worthless, so what are you chances? (What! You had no Plan B? Time to discover The 7Ps of Trading).
Because this is a just a guide, and there’s a limitation to what can be explained – you’ll need to figure out how to identify fundamentally strong companies (in a span of a few minutes) that better your chances of outperforming the market and give you the edge you need to make money.
WHY: When you believe the stock will fall in price, you want to short the stock or you want to hedge a current long holding position – you buy a PUT option contract.
Buying PUTS is useful when you believe the stock or sector is overpriced or going to face trouble.
PUT options will continue to gain value, if the stock goes down. However, there’s a limit… once the stock goes to zero.
Catch 22: The maximum you can lose, is the option price (premium) you paid for each contract. But there’s technically a maximum you can gain here, because the price of the underlying stock cannot go below zero. Also, unlike in traditional short selling (which is selling borrowed stock at a high price and buying it back at a low price) where the losses can be unlimited (if the price of the stock continues to rise), with buying put options – your loss is limited to the option price (premium) you paid.
When you combine buying PUT option contracts with a stock that you already own – then, you’re basically protecting yourself (and your portfolio), this is known as buying ‘protective puts’ or commonly called ‘hedging’ and helps with preserving your capital, rather for capital gains. So when the stock price decreases, the value of the contract will increase, smoothing out your returns.
For example, you already own shares at $50 per share, assuming you had 100 shares – that’s $5,000. Now the price is $70, so that’s $2,000 worth of unrealized gain. If you sold, you would realize a profit of $2,000 – but that also means if the price went up further – you could not benefit. In such a situation, you could buy a put option say at $80 for $2 per contract. That means you’d spend an additional $200 to cover your position. Now, if the markets go up higher, and your contract was exercised – You’d receive your $80 x 100 = $8,000, minus the cost of the option you purchased i.e. $200.
But if the market went down further, and the share price went to $40. And your option was exercised, you wouldn’t have to take the loss of $1,000 by selling at a lower market price.
Buying LEAPS (Long Term Options)
Why: They are less expensive than stocks and not as volatile as short term stock options and as a result, not as sensitive to time decay, until you a few months are left for expiry. Whilst they provide leverage, it’s not as much as short term options, but sufficient for stock traders.
LEAPS is an acronym for Long-term Equity AnticiPation Securities. A mouthful, maybe. These were launched in 1990s, as options that had an expiry as far out as three years. You could say, it was the best of both worlds – for stock traders and option traders.
Selling (Writing) Calls aka Covered Calls
WHY: To earn income on shares you already own (hence ‘covered’ by you), while waiting for your desired sell (higher) price. You’re expecting the stock price to go down or stay flat, you sell a CALL option contract. This is the most conservative option strategy available, and is an income strategy for stocks you already own.
Writing (Selling) Covered Calls – How To Reduce Your Downside Risk: The additional income in the form of premiums you get from selling (writing) options allows you to act like your own fund, and pay distributions to yourself, that the underlying stocks don’t provide. The more uncertainty, the higher the option premiums tend to be, and that translates to richer distributions for investors.
For example, you have 100 shares at $50 (of a good, stable company) and expect it to go to $60 because you’re happy to sell at that price, you can write a covered call for a strike price of $60 (expiring couple of months from now).
In the process, you’ll collect a small premium $2 (per share), so basically you’re selling price is $60 + $2 premium per share. In other words, you’re selling your shares at the price you wanted to and received some extra cash for doing so.
If on the expiry, the closing price is below $60 – you’ll get to keep the premium as additional income and you can start writing a new call option. Rinse and repeat, month after month. Call it ATM cash if you will – it’s simple – write (sell) option, collect cash, lay back and wait, rinse and repeat for as long as you can (read below).
If however, on the expiry, the price is above $60, you are obligated to sell the shares at that price (don’t worry your broker will handle this part for you). If exercised by the market (or as we say assigned) – you will be able to sell for $60 and keep the $2 per share additionally.
“IF” – because there is always a possibility it may not be exercised – but in either case, you win! Not bad eh! Ok, you have capped your upside – but what’s better – a 100% guarantee of $10 or 50% guarantee of $20?
To summarize, if the strike price (stock price at which the option can be exercised) isn’t reached because the price declines, the option expires worthless, and your ‘homemade’ fund can pocket thousands of dollars in premiums by writing options on the same stocks. These premiums help offset the decline in your fund’s underlying portfolio, allowing your fund to outperform its equity index benchmark in weak markets.
Using Covered Calls To Hedge Against Down Markets: The covered call strategy also works best in a flat market, when you believe the stock is going to stagnate for a while but you don’t wish to sell soon. And because of greater uncertainty about the future stock price, there’s generally higher volatility, which factors into the price of the option premium – causing it to go higher. This is good if you want to generate cash flow or produce some income on a dormant position you already have.
Catch 22: Well, when you write a covered call (or sell a CALL option), you must be prepared to give up your shares at the strike price. Again 90% of options (expire worthless) are not exercised until expiration, but they can be exercised early, so be prepared for that at any moment. So that’s the downside… if the market price is much higher than the strike price, there’s a good chance someone might exercise the contract, forcing you to sell and making it easier for them to book a profit while the price is very high and you would not be able to benefit from the upside.
There are a list of stocks, which are ideal for setting up covered calls – that’s because owning them is good, they carry little risk and generally provide a good return.
Selling (Writing) Puts – Cash Secured Puts / Selling Naked Puts
WHY: To get paid while waiting for a lower share price that you’ve been wanting to buy at and you wouldn’t mind buying at a lower price. You’re expecting the stock price to move higher (eventually) or at best remain flat, but would like to collect some premium while you wait, you sell a PUT option contract. Think of this is a stock buying strategy – we call this Cash Secured Puts.
Selling (or as we like to call it ‘writing’) a PUT option contract allows you to get a lower entry price and generate some cash flow while waiting for the stock price to go lower. Normally, you would write the option lower than the current trading price. This actually will allow you to kick start a brand new portfolio, because instead of buying at higher prices immediately, you can write PUT option contracts, wait for the price to fall and if exercised – you’ll have a lower entry price. Some also use this strategy, to average down their price for a particular stock in their portfolio.
For example, you have shares at $50 and expect it to go to $60 BUT you think it ‘could’ move down in the near future, you can sell (write) a PUT option contract for a strike price of $45. One of three scenarios could pan out…
If the price remains above $45 on the expiry date, you get to keep the $2 premium (as the option seller/writer) and you can start the process of selling (writing) another option again – i.e. rinse and repeat.
If the price drops below $45 to $44 on the expiry date, you get to keep the $2 premium (as the option seller) but the option can be exercised by the option holder who bought it (remember, you sold a put option contract to someone, anyways the broker would do this work of assigning it for you) and you would have (been obligated) to buy it at $45 – $2 (because you collected the premium) or $43 per share.
If the price drops way below $45, to say $20 (because the CEO is being held on fraud charges or some creative accounting scam), your entry price would be $43 per share, but you’d still be down. The good news is that your loss would be less than if you had simply bought the stock outright at $45. (The bad news is that if the stock doesn’t recover, you could end up holding it for a very long time!) Anyways overall, options are good way for limiting your losses, and improving your returns.
Catch 22: Well, similar to covered calls – you must be prepared (i.e. ready and happy) – to buy shares if it falls to the strike price. What’s more in order to sell puts, you must have a margin account. You don’t necessarily need to use the margin facility, you just need to keep more cash in the account. The more money you want to make, the larger cash balance you should keep aside or risk having a ‘margin call’ made by your broker. In any case, you’ll require a trading account that has been margin-approved and has all option facilities activated by your broker. Sign up for the bonus section how you can get approved by your broker to operate an online options trading account.
Two Billion Dollar Secrets
… derivatives (options) are financial weapons of mass destruction… – Warren Buffett in the 2002 shareholder letter.
Strange that Warren Buffett would say that, because rich people like him use them. Warren Buffett – the very same guy who said “options are financial weapons of mass destruction” – breaking news – used options to build his empire! Oh wait, yes, not rich people – “sophisticated” rich people. When Warren wants to buy a stock with a large ‘moat’ at a very cheap price – he writes PUT option contracts, because he doesn’t mind buying at a lower price, and while he waits… he’s happy to collect some premium. In his case, those premiums usually run in millions (because he’s buying millions of shares!).
So what was he referring to when he said that? Well, the house always wins (read on and I’ll explain more). Those who ‘speculate’ by buying calls or puts – are basically leveraging rather than simply buying the stock. But as you’ve noticed by now, Covered Calls (selling CALL option contracts) are the most conservative strategy you can use, and together with Protective Puts (selling PUT option contracts) – you can create a winning combination for wealth generation, whilst managing your risk.
… I rarely invest in stocks… – Mark Cuban in CNBC interview.
Mark Cuban became a billionaire, when he sold his company Broadcast.com to Yahoo in the heady days of 1999 (yes that’s the Internet Bubble!) for $5.7 billion in Yahoo stock. But what made this interesting was that Cuban couldn’t sell the stock so easily. So he executed what is called a “collar” trade, and now infamously called the “Cuban Collar”. The trade gave Mark exposure to some upside but limited the downside in a position where he could not sell the stock because of his lock-up period. He basically sold and bought equal premium amounts of calls and puts – effectively a zero cost trade (ignoring commissions). And as fate would have it, the Internet Bubble burst and Yahoo’s stock crashed. But Mark made money.
If you dig into the details, it was a complex trade. But the important take away is that he owned the underlying stock, and he used options to reduce his risk and actually benefit from it.
Start Taking Massive Action
You are READY. What you’ve learned so far is enough to place a simple trade. Of course, this is a beginners guide – and so we haven’t dived into topics such as Moneyness, Greeks, Intrinsic & Extrinsic Value, Probability or even Volatility. Don’t worry, even without these concepts – you should do fine to start, and as you become more experienced – you can learn these concepts. Hopefully, some day you’ll learn not just the basics, but a more advanced options trading technique that puts money in your account, supercharging your gains!
If however, you do get stuck with the basics – then yes, there’s more. You see, some people are visual, some audible, others kinesthetic. So to cater to each type, you can learn in various formats – via ebook, or online training or coaching. Each requires different levels of effort to make you successful. Whatever you opt for, choose the one that’s best for you.
You will not get better at investing and trading by just reading, it requires action – now FIRE. You may have heard of ‘The Cone of Learning’ which was developed in 1969 by Edgar Dale for the education system. He discovered that people retain only 10% of what they read, 20% of what they hear, 30% of what they see. However, they retain 90% of what they practice. Remember…
Practice Is Learning, But Learning Is Not Practice.
To gain confidence, you should try out trades on ‘paper’ before you start to commit real money. This is called paper trading or virtual trading or simulated trading and there are many platforms that can help you do this for free such as ThinkOrSwim, Dough and Interactive Brokers. But just don’t only paper trade, you have to upgrade to the next level because when real money is involved – your real emotions come through!
And don’t worry – you can always course correct along the way… The Banker Bible will be available to help you AIM.