2) How Implied Volatility Works <\/a><\/strong><\/span><\/span><\/p>\n 3) Theta: The Options Trader\u2019s Kryponite<\/a><\/strong><\/span>\u00a0<\/span><\/p>\n Now we\u2019re going to dig into 3 basic options trading strategies that are perfect for beginners.<\/p>\n We\u2019re going to teach you 3 options trading strategies that allow you to speculate on 3 scenarios:<\/p>\n But before you start, there\u2019s 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.<\/p>\n Let\u2019s say Amazon.com<\/b> (AMZN) is trading at $1,000, and you think it\u2019s going to $1,500 in one year.<\/p>\n Here are 7 ways a trader could use options to speculate that move:<\/p>\n Every strategy has pros and cons, and no single one is best.<\/p>\n Please note that all examples in this article are pure hypotheticals — they are not endorsements of these particular trades.<\/p>\n At the time we're writing this,\u00a0Gilead<\/strong> (GILD) was trading at $75.00<\/p>\n Let\u2019s assume we are very bullish on the stock, and believe it can hit $100 in the next 12 months.<\/p>\n The simplest way to speculate on such a movement is to buy call options.<\/p>\n You're probably asking yourself yeah, but which ones?<\/p>\n We can choose between in-the-money, at-the-money, and out-of-the-money calls.<\/p>\n As a quick reminder, for call options, in-the-money options have strike prices below the current stock price.<\/p>\n At-the-money options have strike prices that are about the same as the current stock price.<\/p>\n And out-of-the-money options have strike prices above the current strike price.<\/p>\n You can see relationship here:<\/p>\n So which one is best?<\/p>\n In the money, at the money, or out of the money calls?<\/p>\n The answer is\u2026 none of them and all of them.<\/p>\n Let\u2019s look at the differences.<\/p>\n Here's a table detailing the major differences between in and out-of-the-money options:<\/p>\n Let's look at some numbers to illustrate these differences.<\/p>\n Here are the prices of GILD call options with 24 days to expiration, with the stock trading at $75:<\/p>\n The at-the-money $75 call is priced at $1.98.<\/p>\n The in-the-money $70 call is $5.40.<\/p>\n And the out-of-the-money $80 call is just $0.65.<\/p>\n And as you can see, the in-the-money options cost more up front, and the out-of-the-money options cost less.<\/p>\n This is because the in-the-money options have intrinsic value, and have a higher chance of being in the money at expiration.<\/p>\n And that\u2019s the tradeoff: you pay more for in-the-money options, but the option has a higher likelihood of being in the money.<\/p>\n On the flipside, out-of-the-money options cost less up front, but give you a lower likelihood of success.<\/p>\n 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.<\/p>\n Let\u2019s take a look at possible payoffs of each option at expiration under a variety of price scenarios.<\/p>\n On this table, here is what each option would be worth at expiration under different price scenarios:<\/p>\n Let\u2019s assume GILD goes flat, and is at $75 at expiration.<\/p>\n Focus on the middle column of that table.<\/p>\n 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.<\/p>\n And the $75, $80, and $85 calls would be worth zero.<\/p>\n Now let's take a look at the P&L of these options:<\/p>\n 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:<\/p>\n The $85 calls would expire out of the money and be worthless, giving a 100% loss of the $0.19 premium paid.<\/p>\n The $65 calls would give you the largest dollar profit at $9.23.<\/p>\n Here's a third table showing the P&L on a on a percentage basis:<\/p>\n As you can see, the $80 calls would give you the highest profit at $669%<\/p>\n They cost just $0.65, and rose to $4.35.<\/p>\n But remember the trade offs we discussed earlier:<\/p>\n Out-of-the-money options cost less up front, but give you a lower chance of success.<\/p>\n 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.<\/p>\n We can also choose between shorter-dated and longer-dated options.<\/p>\n If you recall from our article on time\u2019s role in options pricing<\/a><\/strong>, longer-dated options cost more than shorter-dated options.<\/p>\n As you can see on this chart, the more days there are to expiration, the higher the price of the option is:<\/p>\n The call option expiring in 3 days costs just $0.88. And the one with 31 days to expiration costs $2.77.<\/p>\n Through this options series, we\u2019ve compared options to car insurance.<\/p>\n A call option is an insurance contract that pays off when the stock rises.<\/p>\n Ask yourself this: would it cost more to insure your car for 1 year?<\/p>\n Or 2 years?<\/p>\n Obviously, you pay more for 2 years of insurance coverage than 1.<\/p>\n Why?<\/p>\n Because over a 2-year period, there\u2019s a much greater chance of something happening than over 1 year.<\/p>\n So how should you choose which call options to trade?<\/p>\n There is no simple answer.<\/p>\n We recommend figuring out where you think the underlying stock could go within a certain time frame.<\/p>\n 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).<\/p>\n At the time of this writing on November 9, 2017, shares of software giant Microsoft<\/b> (MSFT) were trading at $84.<\/p>\n Let\u2019s assume we think the stock will trade to $85 by year-end.<\/p>\n That\u2019s a measly 1.2% gain.<\/p>\n Let\u2019s assume we\u2019re looking at buying the $84 call options expiring on on December 29, which are trading at $1.75.<\/p>\n So there\u2019s a problem here.<\/p>\n If we buy the $84 calls for $1.75, and the stock is trading $85 at expiration, we\u2019ll end up losing money.<\/p>\n 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)<\/p>\n You can see that on this table:<\/p>\n Let\u2019s add a twist.<\/p>\n We will still assume Microsoft trades to $85 at expiration.<\/p>\n In this case, all options on that expirations with strike prices above $85 would expire worthless.<\/p>\n So we can actually short those options with higher strike prices against the $84 call we are buying, creating a bull call spread.<\/p>\n For example, we could do the following:<\/p>\n The total cost of the trade is just 75 cents per lot.<\/p>\n Typically, bull call spreads are done with an equal number of contracts for each part (or leg) of the trade.<\/p>\n Remember what a call option is.<\/p>\n It\u2019s the right to buy a certain stock at a certain price by a certain expiration date.<\/p>\n 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.<\/p>\n This brings our cost basis down, but it also caps our upside.<\/p>\n Take a look at this table:<\/p>\n 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%.<\/p>\n But how much can we make on a bull call spread in the best case scenario.<\/p>\n At expiration, a bull call spread\u2019s maximum value is the difference between the two strike prices.<\/p>\n In our example, that\u2019s $2 ($86 – $84). That would give a profit of $1.25<\/p>\n 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.<\/p>\n 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.<\/p>\n Meanwhile, if we\u2019d just bought the $84 call straight up, it would be worth $4.00, and we\u2019d have a profit of $2.25 per lot, which you can see on the right column here:<\/p>\n And that\u2019s the tradeoff with bull call spreads. You pay less up front, but you also cap your upside.<\/p>\n But if you think a stock will only make a small move, that\u2019s a pretty good tradeoff.<\/p>\n 3) Using Bear Call Spreads to Speculate on a Stock Doing Nothing<\/b><\/p>\n Let\u2019s take a look at social media giant Facebook <\/b>(FB).<\/p>\n As we\u2019re writing this on November 9, 2017, the stock was trading at $179.<\/p>\n Let\u2019s assume we think the stock will trade flat through the December 29 year-end expiration.<\/p>\n At expiration, if the stock is trading at $179 at expiration, call options with strike prices of $179 or above will expire worthless.<\/p>\n And we want to sell call options that we think will expire worthless.<\/p>\n Let\u2019s take the $180 call, which is trading at $5.<\/p>\n If Facebook went to $200, that $180 call would be worth $20.<\/p>\n So if we short at $5 and it goes to $20, we\u2019d lose $15 a contract, or $1,500!<\/p>\n We can mitigate that risk by buying a higher priced call against the $180 call we\u2019re selling.<\/p>\n For example, we could buy the $190 call for $2<\/p>\n The bear call spread would be structured as follows:<\/p>\n So we would actually take in a credit of $3, because we are selling at $5 and buying at $2.<\/p>\n When we take in money on an options trade, we say we are doing the trade for a credit.<\/p>\n As you may have noticed, this trade is the polar opposite of the Microsoft bull call spread we showed above.<\/p>\n Here\u2019s a table showing the differences between bull and call spreads so you can understand them better:<\/p>\n And like with bull call spreads, the maximum value of a bear call spread is the difference between the strike prices.<\/p>\n With our Facebook example, that would be $10 ($190 – $180).<\/p>\n Since our bear call spread was priced at $3, that means we could suffer a maximum loss of $7 (or $700 per lot).<\/p>\n That is calculated as the maximum potential value of $10 minus the $3 premium we took in.<\/p>\n Let\u2019s look at a table showing the potential value of the $190-$180 call spread based on different stock prices values at expiration<\/p>\n As you can see on our table, if Facebook traded to $190 or above, we would incur the maximum loss of $7.<\/p>\n Our breakeven is $183 (the lower strike plus our $3 credit).<\/p>\n And if Facebook traded at $180 or less at expiration, we would earn our maximum profit of $3.<\/p>\n 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.<\/p>\n On the negative side, if the stock skyrockets, we could take a substantial loss.<\/p>\n Therefore, you need a high degree in confidence that the stock will not rise.<\/p>\n Conclusion<\/strong><\/p>\n We selected these 3 simple strategies because they are easy to understand, and simple to execute.<\/p>\n If you have any questions, please leave them in the comments section below.<\/p>\n Did you miss the first 3 articles in this series? Check them out below:<\/p>\n 1) The ABC\u2019s of Puts and Calls<\/a><\/strong><\/span>\u00a0<\/span><\/p>\n 2) How Implied Volatility Works <\/a><\/strong><\/span><\/span><\/p>\n 3) Theta: The Options Trader\u2019s Kryponite<\/a><\/strong><\/span>\u00a0<\/span><\/p>\n\n
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Strategy #1:\u00a0<\/b>Buying Call Options to Speculate on a Big Rally<\/b><\/h3>\n
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<\/p>\nStrategy #2: Buying a Bull Call Spread to Speculate on a Small Rally<\/b><\/h3>\n
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