Small Investment, High Potential Return: What’s Not to Love About Options?

Option trading provides a unique way to leverage the price moves of the market. Never has this been more apparent than in the last few weeks. To clarify some of the differences with trading in actual stocks, try to remember these two crucial points. As an option trader, you make money by purchasing the “right” to buy or sell an equity, and that right in itself has value and gives you, the trader, leveraging power. You will never need to worry about finding an interested buyer; through the option contract itself, the sale is guaranteed the moment that you decide to sell, providing you have purchased an option with a level of open interest.

Most of us are accustomed to thinking of the stock market as an exchange in which you buy and own actual shares of stock, and then decide to sell for various reasons. Therefore, it sometimes requires a new mindset to fully appreciate the value of an “option”.

The option premium is the amount you pay to control the underlying equity. This option premium increases in a magnified way when compared with the underlying equity price: As the equity’s price goes up, the value of your option also increases. Then you sell your option to someone else, well before the option’s expiration date. In that way, you trade the options, but never actually buy or sell the underlying stock.

If you buy an option on a stock, you can think of the option as a “down payment” on that stock. Imagine purchasing an option on 100 shares of American Express stock to control the financial power of those 100 shares.

To make this even more clear, let’s compare a stock purchase to an option purchase.

If  American Express’s (AXP) stock price is $90 per share, 100 shares of stock would cost $9,000. If next month, the stock price goes up $2 and you sell the stock, you have a profit of $200 on your 100 shares. Your profit is just over 2.2%.

However, if you buy a Call Option on those same 100 shares of AXP stock, you will pay approximately $2.50. (This is a good estimate, but the actual option prices vary greatly). This $250 controls all 100 shares of    AXP stock.

If American Express’s stock price goes up $2, your option may also go up $2. (This varies according to the underlying option).

This $2 increase or $200 profit is 80% of the initial price you paid for the option. Using the leverage of options, you’ve made 80% profit on the same underlying equity (stock) that only realized (gained) a 2.2% profit when the actual stock was sold.

  • 100 shares @ $90 = $9,000 
  • $2 increase x 100 shares = $200 
  • New Value = $9,200
  • Gain 2%

Or

  • 1 Option contract on 100 shares @ $2.50 per share = $250
  • $2 increase in option price x 100 shares = $200
  • New Value = $450
  • Gain 80%

I don’t know about you, but I will take an 80% gain over 2.2% with a smaller capital outlay every day. It is evident that options provide traders with two benefits. You can begin trading with a small amount of money. You can turn a high percentage of profit. Sounds great, right?

As you begin to practice trading, your confidence increases, and you can earn even greater profits. With careful, precise trading, a $200 profit can become $400, $400 can become $800 and, before long, a trading account will increase, showing exponential or “compounded” profit.

Here’s a Story to Illustrate How an Option Works

Imagine you have a friend who wants to sell his house for $200,000. You are familiar with the subdivision, and you like the nearby golf course that makes the area desirable, but you don’t have the $200,000 to purchase the house as an investment, so you offer another proposal.

“If you’ll give me a piece of paper saying I can purchase your house for $200,000 any time over the next twelve months,” you say to your friend, “I will give you an extra $10,000.”

Your friend accepts your proposal because it’s not important to him that he sells today. In essence, you have bought an option – an option to purchase the house at a later, agreed-upon date.

Eight months later, a new elementary school is under construction a half-mile away, making the properties in the area in hot demand. Now the house has gone up in price to $230,000.

You hold up your paper—the option—and wave it in front of interested buyers. “I’ll sell you this paper for $15,000. It states that you can purchase this $230,000 house for only $200,000.”

Someone takes you up on your offer, and the trade is made.

Let’s break down what happened from here.

Your friend receives the $200,000 he wanted for his house, in addition to the $10,000 you paid for the option to purchase his property.

The new buyer purchases a house valued at $230,000 for $200,000, plus the$15,000 he paid you for the paper option. He pays a total of $215,000, a savings to him of $15,000.

And, you receive $15,000 for the option (paper) you paid $10,000 for eight months ago, so you made a $5,000 profit on your $10,000 investment. That means that you realized an astounding 50% return within eight months.

My story illustrates in a simple way the crux of the “secret” world of trading options. In the story, you see the house, the owner, and the buyer. They are all tangible to you.

In the world of Wall Street, it’s all like “invisible pieces of paper,” so to speak, especially when the transactions take place online. However, the principle is the same. You control enough of a great stock to make a great deal of money with essentially only a down payment.

Most of us can’t go out and simply plunk down $200,000 to invest in an “underlying instrument,” like a second house or a block of stocks. But you can benefit from the leverage of controlling the “underlying” with a fraction of the house or stock cost by using options.

The leverage of options allows you to profit by a substantial amount, in the same way a pulley leverages weight so you can lift more than physically possible. Options give you profit leverage that builds wealth.

You can achieve significant short-term profits on the money you invest in option contracts. You profit by purchasing option contracts, called Calls and Puts, with the express intention of selling the contract after the equity (the stock, ETF, or index,) has moved in price, either up as with Calls, or down as with Puts, and you sell well before the option’s expiration date. As with the house, you have the right to purchase the equity at the price you agreed upon in the options contract, but in fact you never intend to do so. Your profit is made on the price movement and exiting the contract before its expiration date.

When you purchase an unripe banana on the produce aisle of the grocery store, you know the banana still has a long time before it has to be eaten. In terms of options, the idea is to sell the banana before it becomes yellow with brown spots, soft and ready to expire.

By using this strategy, you never exercise your option to buy the underlying equity. Your goal is to hold the option long enough for the price of the equity to move in the direction that you predicted when you purchased the contract. You don’t intend to exercise the option (you never eat the banana), but someone else will want to make banana nut bread, so that now ripe banana you are holding has value to someone else that they are willing to pay for.

Market Trends: Something to Bear or a Bunch of Bull?

The terms “bullish” and “bearish” are terms that are bandied about stock market gurus and financial commentators with great regularity, particularly in today’s market, which has been ripe with bearish reversals and bullish rebounds. New option traders often hear these discussions and are uncertain about the real impact of these trends. Let’s touch on this just briefly.

Consider this – If Google or some other major industry comes to your town and brings new jobs and adds money to the economy, then chances are the other businesses in your area will experience an increase in business. If your town loses a major employer, the other local businesses may report a decrease in business because less money is circulating.

In the same way, economic trends influence Wall Street, and stocks have a herd effect, so to speak. When economic trends are on the rise and equities are increasing in value because investors are confident in the economic future of the market, then we’re said to be in a “bull market,” or traders are said to be “bullish”. On the other hand, in times of economic distress or uncertainty, or a dramatic event makes the market “jittery,” then stocks may decline in value, and analysts say we’re in a “bear market,” or traders are “bearish”.

Stocks rise and fall on a daily basis, and you don’t assign the terms “bull” or “bear” based on one day or a week’s performance – and the terms are relative as well. The market can be “bearish” for a period of time when other economic forecasts seem uncertain. On the other hand, the market can turn “bullish” when certain indicators point to economic expansion.

In a bull market, when the overall market is going up, successful option traders buy and sell their Call Options. It is counterproductive to go against the flow of the market, or, to express this concept another way, it doesn’t make sense to ignore the upward bias of the market.

Likewise, in a bear market, when the overall market is trending to lower stock prices, then successful option traders consider purchasing and selling their Put Options.

The past four days in the market have brought bearish reversals with the major indices opening high and then ending each day with small gains or incremental losses. With the current volatility in the market, short-term option traders can make gains on all this price movement. However, it will be important to use a specific trade strategy with clear entry/exit signals to avoid being fooled by short-term market corrections and trend reversals that only benefit day traders.

Still honing your trading skills? Not to worry. Kirkland Trading Academy offers a variety of products to support your learning process. Visit https://www.optiontradinginyoursparetime.com for details and follow our blog for quick e-learning updates.

The Market: Is it Time for a Diet, or Will We Head Back for Dessert?

I know firsthand that the easiest way to begin the journey into option trading is to find a way to relate to it. Many people, even those who trade stocks regularly, consider the stock market itself a big mystery, an enigma, which is why I think it’s the best place to begin. What’s actually behind the symbols and numbers you see on the crawls at the bottom of the TV screen or in the columns of fine print you see in the newspaper?

As a woman who once thought of the stock market as an abstract and baffling concept, I found it helpful to think of the market as a living being. Instead of thinking of it as being comprised of mathematical equations, it’s made up of companies (including their stock and its products or services, employees and associates) that move around in groups. As a living entity, the market inhales, or expands, and exhales, or contracts, and at times it holds its breath.

Said another way:

  • During times of expansion, the market increases in value, or “puts on weight.”
  • During times of contraction, its value (weight) goes down, as if “losing weight.”
  • When the market holds its breath, it maintains its value, or weight, and moves sideways.

As we have seen in past months, the market has been putting on additional “weight” on a daily basis and, just as it would be for an average person, this kind of gain is difficult to sustain. As we have seen this week, there is a weight limit for the market, where indicators show that it is time to step away from the table. Time will tell if this is a short term loss in weight (much like my New Year’s resolutions 🙂 ) or a confirmed trend to balance out the health of the market.

Is there an upside to a down-trending market? In the options world there is. Remember, that Put options allow you to benefit from price declines. Typically, these are shorter positions than a Call.

The current fluctuation in “weight” could provide option traders with some ripe opportunities as the bulls and bears debate whether it’s time for more dessert or for a diet.

This debate brings the separate concepts of price and value into play. Simply said, while buyers and sellers can come to an agreement on price, they do not always agree on value.

When it comes to stocks, a trade takes place when one buyer is eager to sell stock at the same time another buyer wants to make a purchase. Quite often, when a stock drops in price, a trader is anxious to get rid of the equity, while another trader sees the drop in price as an opportunity to purchase an undervalued stock at a bargain price.

Value versus price is subjective. One company’s stock price may trade at fourteen times its earnings and will be considered undervalued with room to grow. Another company’s stock may trade at six times its earnings and will be considered overpriced and at its peak.

There are other influences that illustrate this difference in evaluation. An analyst group (Oppenheimer & Co., for example) may upgrade a stock based on their expectation of future earnings for that company, and the next day the stock’s price will soar. Nothing has actually changed to bring about this increase in value, except an expectation, a belief that good things are apt to happen. If this hope is not realized, the stock will drop back to its actual worth, or even below that level for a time, until the next event. A company’s reported earnings may disappoint analysts and traders, but, if the company’s outlook for the coming quarter is encouraging, the stock may still rally into the next quarter. Value and price are separate concepts.

As the bulls and bears fight for control of the market this week and in the short term, this debate over what will amount to the long-term health of the market as an entity creates trading opportunities. In the options world, there are investors buying more bearish Puts than Calls, indicating more interest in market correction than in purchasing low-priced, high-value stocks while the market is ripe for it. Time will tell if the market will remain on its diet or give in and begin putting on weight once more.