An Introduction to Option strategy
Bryan Chops
Investor extraordinaire
If you haven't done options trading before, don't worry, it is easier than you might think. I have been options trading for over 25 years, and I have helped thousands of individuals learn what options are, how to trade options, and learn basic option strategies.
The first thing you must understand is that a stock price can move in 3 directions:
- 1. It can go up.
- 2. It can go down.
- 3. It can stay the same.
The second thing you must remember is that a "call option" gives you the right to buy a stock at a certain price by a certain date; and a "put option" gives you the right to sell a stock at a certain price by a certain date. You can remember the difference easily by thinking a "call option" allows you to call the stock away from someone, and a "put option" allows you to put the stock or sell it to someone.
In this example, the Microsoft 25 Call Option is priced at $1.00, therefore the maximum loss is $1. If Microsoft closes above the $25 exercise price, then the trade starts to move in our favor. If Microsoft closes above the Breakeven Point of $26 (which is the sum of the cost of the option plus the Exercise Price) the trade is profitable.
The third thing to remember is a few key terms. The "strike price" is the price at which you have the right to buy (if we are talking call options) or the right to sell (if we are talking put options). The "expiration month" is the month in which the option will expire (the exact date is usually the 3rd Friday of each month).
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The final thing you must understand is that if you think a stock is going to go up, there are 3 ways to make money:
- 1. You can buy the stock.
- 2. You can buy a call option on the stock.
- 3. You can sell a put.
Likewise, if you think a stock is going to go down, there are also 3 ways to make money:
- 1. You can short the stock
- 2. You can buy a put option on the stock, and
- 3. You can sell a call
|
Website |
Realt-Time
or Delayed |
Order
Types |
Securities
Types |
Create Contest |
Cost |
 |
WallStreetSurvivor.com |
Real-Time |
Limit/Stop |
Stocks/Options |
Yes |
FREE |
 |
StockTrak.com |
Real-Time |
Limit/Stop |
Stocks/Options/Futures |
Yes |
Small Fee |
 |
HowTheMarketWorks.com |
Real-Time |
Limit/Stop |
Stocks/Funds |
Yes |
FREE |
Now let's look at a specific example so this starts making sense. Let's say we have done our analysis on IBM and we think IBM will go from $84 to $87 in the next few days. Because I think IBM will go up I want to buy a call and since option strike prices are typically in multiples of $5, I could buy the $80 call, the $85 call, or the $90 call. Note from the Table 1 below that the IBM April 85 Call has the greatest percentage return.
Scenario 1:
Buy 100 Shares of Stock and 1 Contract of Each of the $80, $85, and $90 Calls and IBM Closes at $87.
|
Security |
Shares |
Purchase Price |
Cost |
Selling Price |
Proceeds |
Profit |
% Return |
|
|
Stock |
100 |
$84.00 |
$(8,400.00) |
$87.00 |
$8,700 |
$300.00 |
3.57% |
|
|
IBM April 80 Call |
1 |
$4.00 |
$(400.00) |
$7.00 |
$700 |
$300.00 |
75% |
|
|
IBM April 85 Call |
112 |
$0.75 |
$(75.00) |
$2.00 |
$200 |
$125.00 |
167% |
|
|
IBM April 90 Call |
336 |
$0.25 |
$(25.00) |
$ - |
$ - |
$25.00 |
100% |
|
Scenario 2:
Invest Equal Amounts of Money in Each Stock and Option and IBM Closes at $87.
|
Security |
Shares |
Purchase Price |
Cost |
Selling Price |
Proceeds |
Profit |
% Return |
|
|
Stock |
100 |
$84.00 |
$(8,400.00) |
$87 |
$8,700.00 |
$300.00 |
3.57% |
|
|
IBM April 80 Call |
21 |
$4.00 |
$(8,400.00) |
$7.00 |
$14,700 |
$6,300.00 |
75.00% |
|
|
IBM April 85 Call |
112 |
$0.75 |
$(8,400.00) |
$2.00 |
$22,400.00 |
$14,000.00 |
166.67% |
|
|
IBM April 90 Call |
336 |
$0.25 |
$(8,400.00) |
$ - |
$ - |
$8,400.00 |
-100.00% |
|
Now, here's the risky part of trading options. In Table 1 and Table 2 we showed the results assuming IBM climbed from $84 to $87 a share by the expiration date. Of course, stocks don't always move the way we think, so Table 3 shows what happens if the stock price just declines a bit to $83 a share. Note that for the $85 Call we lost all of our money, but for the $80 Call we only lost $2,100 and, of course, for the stock we only lost the $100.
Scenario 3:
IBM Closes at $83.00.
|
Security |
Shares |
Purchase Price |
Cost |
Selling Price |
Proceeds |
Profit |
% Return |
|
|
Stock |
100 |
$84.00 |
$(8,400) |
$83.00 |
$8,300.00 |
$(100.00) |
-1.19% |
|
|
IBM April 80 Call |
21 |
$4.00 |
$(8,400) |
$3.00 |
$6,300.00 |
$(2,100.00) |
-25.00% |
|
|
IBM April 85 Call |
112 |
$0.75 |
$(8,400) |
$ - |
$ - |
$8,400.00 |
-100% |
|
|
IBM April 90 Call |
336 |
$0.25 |
$(8,400) |
$ - |
$ - |
$8,400.00 |
-100.00% |
|
Conclusion: How to Trade Options
If you are confident that a stock is going to go up a few points before the next option expiration date, it is the most profitable (and the most risky) to buy a call option with a strike price slightly higher than the current stock price. If you want to be a little more conservative, you can also buy the call option with a strike price below the current stock price. When in doubt as to what option to buy, always look at the volume that is happening in the real market and go where the volume is (I call this following the "smart money").
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