Welcome back to our Introduction to Options series!
By now we’ve covered:
Now we’re going to dig into 3 basic options trading strategies that are perfect for beginners.
We’re going to teach you 3 options trading strategies that allow you to speculate on 3 scenarios:
But before you start, there’s one thing you must understand about options trading: for every stock scenario you can think of, there are 1 million ways to play it with options.
Let’s say Amazon.com (AMZN) is trading at $1,000, and you think it’s going to $1,500 in one year.
Here are 7 ways a trader could use options to speculate that move:
Every strategy has pros and cons, and no single one is best.
Please note that all examples in this article are pure hypotheticals — they are not endorsements of these particular trades.
At the time we're writing this, Gilead (GILD) was trading at $75.00
Let’s assume we are very bullish on the stock, and believe it can hit $100 in the next 12 months.
The simplest way to speculate on such a movement is to buy call options.
You're probably asking yourself yeah, but which ones?
We can choose between in-the-money, at-the-money, and out-of-the-money calls.
As a quick reminder, for call options, in-the-money options have strike prices below the current stock price.
At-the-money options have strike prices that are about the same as the current stock price.
And out-of-the-money options have strike prices above the current strike price.
You can see relationship here:
So which one is best?
In the money, at the money, or out of the money calls?
The answer is… none of them and all of them.
Let’s look at the differences.
Here's a table detailing the major differences between in and out-of-the-money options:
Let's look at some numbers to illustrate these differences.
Here are the prices of GILD call options with 24 days to expiration, with the stock trading at $75:
The at-the-money $75 call is priced at $1.98.
The in-the-money $70 call is $5.40.
And the out-of-the-money $80 call is just $0.65.
And as you can see, the in-the-money options cost more up front, and the out-of-the-money options cost less.
This is because the in-the-money options have intrinsic value, and have a higher chance of being in the money at expiration.
And that’s the tradeoff: you pay more for in-the-money options, but the option has a higher likelihood of being in the money.
On the flipside, out-of-the-money options cost less up front, but give you a lower likelihood of success.
And because they cost less, out-of-the-money options can give you a bigger percentage gain if the underlying stock makes a big move in your favor.
Let’s take a look at possible payoffs of each option at expiration under a variety of price scenarios.
On this table, here is what each option would be worth at expiration under different price scenarios:
Let’s assume GILD goes flat, and is at $75 at expiration.
Focus on the middle column of that table.
As you can see, if GILD went to $75, the $65 calls would still be worth $10 ($75 – $65) — just a little less than the $10.77 cost.
And the $75, $80, and $85 calls would be worth zero.
Now let's take a look at the P&L of these options:
As you can see on the right column on the table, if GILD is at $85 at expiration, the $65, $70, $75, and $80 calls would have value:
The $85 calls would expire out of the money and be worthless, giving a 100% loss of the $0.19 premium paid.
The $65 calls would give you the largest dollar profit at $9.23.
Here's a third table showing the P&L on a on a percentage basis:
As you can see, the $80 calls would give you the highest profit at $669%
They cost just $0.65, and rose to $4.35.
But remember the trade offs we discussed earlier:
Out-of-the-money options cost less up front, but give you a lower chance of success.
And because they cost less, out-of-the-money options can give you a bigger percentage gain if the underlying stock moves in your favor.
We can also choose between shorter-dated and longer-dated options.
If you recall from our article on time’s role in options pricing, longer-dated options cost more than shorter-dated options.
As you can see on this chart, the more days there are to expiration, the higher the price of the option is:
The call option expiring in 3 days costs just $0.88. And the one with 31 days to expiration costs $2.77.
Through this options series, we’ve compared options to car insurance.
A call option is an insurance contract that pays off when the stock rises.
Ask yourself this: would it cost more to insure your car for 1 year?
Or 2 years?
Obviously, you pay more for 2 years of insurance coverage than 1.
Because over a 2-year period, there’s a much greater chance of something happening than over 1 year.
So how should you choose which call options to trade?
There is no simple answer.
We recommend figuring out where you think the underlying stock could go within a certain time frame.
Then, decide what's more important: paying more money up front with a higher chance of success (in or at-the-money options), or paying less up front with a lower chance of success (out of the money options).
At the time of this writing on November 9, 2017, shares of software giant Microsoft (MSFT) were trading at $84.
Let’s assume we think the stock will trade to $85 by year-end.
That’s a measly 1.2% gain.
Let’s assume we’re looking at buying the $84 call options expiring on on December 29, which are trading at $1.75.
So there’s a problem here.
If we buy the $84 calls for $1.75, and the stock is trading $85 at expiration, we’ll end up losing money.
At expiration, if the stock is at $85, those $84 calls will be worth only $1. So we would lose $0.75 per contract. (Our cost basis of $1.75 minus the current value of $1)
You can see that on this table:
Let’s add a twist.
We will still assume Microsoft trades to $85 at expiration.
In this case, all options on that expirations with strike prices above $85 would expire worthless.
So we can actually short those options with higher strike prices against the $84 call we are buying, creating a bull call spread.
For example, we could do the following:
The total cost of the trade is just 75 cents per lot.
Typically, bull call spreads are done with an equal number of contracts for each part (or leg) of the trade.
Remember what a call option is.
It’s the right to buy a certain stock at a certain price by a certain expiration date.
So if we sell the $86 call, we take on the obligation of selling the stock at $86 to another party. In exchange for that obligation, we receive our $1 premium.
This brings our cost basis down, but it also caps our upside.
Take a look at this table:
If we bought the $84-$86 bull call spread and the stock was at $85 at expiration, we'd earn a profit of $0.25 on the $0.75 we paid for the spread. That's 33%.
But how much can we make on a bull call spread in the best case scenario.
At expiration, a bull call spread’s maximum value is the difference between the two strike prices.
In our example, that’s $2 ($86 – $84). That would give a profit of $1.25
The call spread will hit that $2 maximum value if the stock price is at or above the higher strike price of $86 at expiration.
As you can see on the table above, even if Microsoft is at $88 at expiration, the call spread will still only be worth $2, and our profit will still be $1.25 per lot.
Meanwhile, if we’d just bought the $84 call straight up, it would be worth $4.00, and we’d have a profit of $2.25 per lot, which you can see on the right column here:
And that’s the tradeoff with bull call spreads. You pay less up front, but you also cap your upside.
But if you think a stock will only make a small move, that’s a pretty good tradeoff.
3) Using Bear Call Spreads to Speculate on a Stock Doing Nothing
Let’s take a look at social media giant Facebook (FB).
As we’re writing this on November 9, 2017, the stock was trading at $179.
Let’s assume we think the stock will trade flat through the December 29 year-end expiration.
At expiration, if the stock is trading at $179 at expiration, call options with strike prices of $179 or above will expire worthless.
And we want to sell call options that we think will expire worthless.
Let’s take the $180 call, which is trading at $5.
If Facebook went to $200, that $180 call would be worth $20.
So if we short at $5 and it goes to $20, we’d lose $15 a contract, or $1,500!
We can mitigate that risk by buying a higher priced call against the $180 call we’re selling.
For example, we could buy the $190 call for $2
The bear call spread would be structured as follows:
So we would actually take in a credit of $3, because we are selling at $5 and buying at $2.
When we take in money on an options trade, we say we are doing the trade for a credit.
As you may have noticed, this trade is the polar opposite of the Microsoft bull call spread we showed above.
Here’s a table showing the differences between bull and call spreads so you can understand them better:
And like with bull call spreads, the maximum value of a bear call spread is the difference between the strike prices.
With our Facebook example, that would be $10 ($190 – $180).
Since our bear call spread was priced at $3, that means we could suffer a maximum loss of $7 (or $700 per lot).
That is calculated as the maximum potential value of $10 minus the $3 premium we took in.
Let’s look at a table showing the potential value of the $190-$180 call spread based on different stock prices values at expiration
As you can see on our table, if Facebook traded to $190 or above, we would incur the maximum loss of $7.
Our breakeven is $183 (the lower strike plus our $3 credit).
And if Facebook traded at $180 or less at expiration, we would earn our maximum profit of $3.
So as you can see, if Facebook stays around the $179 stock price, we could make a nice a profit. And since we took in that $3 credit, we could put that money to work in other investments.
On the negative side, if the stock skyrockets, we could take a substantial loss.
Therefore, you need a high degree in confidence that the stock will not rise.
We selected these 3 simple strategies because they are easy to understand, and simple to execute.
If you have any questions, please leave them in the comments section below.
Did you miss the first 3 articles in this series? Check them out below: