Understanding Options and Buying Calls
Hi, my name is Jeff Clark and I'm an options trader. I also write a couple options related newsletters for Stansberry & Associates. If you ask me what I do for a living, I trade options. I've been doing it for 28 years. I've also been teaching folks just like you how to trade options successfully in the market.
I've learned a few things during that time... including how to make a successful options trade and some of the things you're not supposed to do. I've also learned that there's a huge gap between what most people think about options and what options are really designed for.
The purpose of this DVD is to try to teach you a little bit more about the real world of options trading so you gain additional knowledge, and work a little bit with the structure of what makes for good option trades.
Now... when you talk about options, most people think "risk." They think dangerous leverage. They think speculation. They think gambling. And I guess there is that aspect to it, if you're stupid...
See, most people don't understand options. The reason they were created in the first place is to reduce risk. In fact, the original options were designed to help investors hedge their portfolios against bad moves in the market. Unfortunately, what's happened over time is what happens to a lot of good ideas on Wall Street... options have morphed into a commission-generating vehicle they sell to folks as a way to get rich quick.
Well folks, if you bought this DVD thinking you're going to learn some sort of strategy that's designed to help you get rich quick, I've got some bad news for you. That's not the point here. We'll show you some strategies. We'll show you how to make money. We might even show you how to get rich. But it's not going to happen overnight. Trading options is a process. And if you want to be in the options market for any length of time... if you want to trade up to 28 years like me... you have to do it the right way.
Options are really designed to reduce risk and add a little bit of pop to a conservative portfolio. That's a really important statement. In fact, it's brilliant. I'm going to say it again. Options are designed as a vehicle to reduce risk and to add a little bit of pop to an otherwise conservatively structured portfolio. The truth is, most people lose money trading options because they do stupid things with them.
We're going to show you in this DVD series how not to do stupid things. We're going to do the smart things. We're going to use options for what they are really designed to do. We're going to show you strategies that help you reduce risk. We're going to show you strategies that help you create income. And we're going to show you strategies that will add a little bit of pop to your portfolio, so you can trade in the markets for a long period of time and enjoy the real benefits of options trading. So with that in mind, let's get right to it....
Understand that options are contracts. Options give you the right to buy or sell a specific stock at a specific date at a specific price. There are only two types of options. You have call options and you have put options. The call option gives you the right to buy a stock. A put option gives you the right to sell a stock. And there are four basic strategies you can use with options.
- You can buy a call.
- You can buy a put.
- You can sell a call.
- You can sell a put.
You don't have to be a genius to remember them.
In this DVD series, we're going to work through those four basic strategies and show you how to use them to reduce risk and add a little bit of pop to your portfolio.
So let's try this. Whether you're trading options or simply learning about trading them, the first thing you need to do is to be comfortable. So go ahead... take off your jacket, loosen your tie, wrap yourself up in a Snuggie if you need to... whatever it takes to be comfortable. Let's go ahead and take a look at an option trade...
Let's say Intel (INTC) is trading for about $20 a share. You buy 100 shares of the stock at $20. No rocket science here. You're buying the stock.
Now, there are three things that can happen when you buy a stock... The stock can go up, it can go down, or it can stay the same.
If we're buying 100 shares of Intel, we're obviously hoping that the stock goes higher. Let's say we think it can go up 10% in the next two months. So we think Intel – which is currently trading around $20 – can eventually make it to $22. If we buy 100 shares at $20 and it rises to $22, we've made $200, or roughly 10% on the trade.
The other thing that can happen to Intel is it could fall in price. How low? Well, technically it could go to zero. Is that likely? Probably not. But it didn't seem likely that Lehman Brothers or General Motors would go to zero either, so you do have to keep that in mind. Any time you're trading stocks, you do have some risk.
So yes, it's possible, in the next few months you could make 10% on Intel. It's also possible that you could lose 100%. And it's also possible that nothing at all can happen. You buy Intel today at $20, and two months from now, Intel is in the exact same spot. So you can make money, lose money, or break even.
What I want to focus on are these two numbers: making 10% or losing 100%. As an options trader, remember what the purpose of options is – to reduce risk and add a little bit of pop to your portfolio. I don't like the possibility of losing 100%, or $2,000 on 100 shares (100 shares x $20 per share = $2,000). I'm also not a huge fan of making just 10%. If there was a 10% move in the stock, I'll make just $200 on that. Well, options give you the opportunity to reduce your risk and increase your return.
Let me show you how that works...
Like I said before, an option is a contract. It gives you the right to buy or sell a stock at a specific price by some predetermined date in the future. Let's continue with our Intel example...
Since we like Intel, we're thinking of buying the shares. We're going to use the first options strategy, which is to buy calls. If we buy calls, we pay a premium and have the right to buy the stock. So we're not buying Intel itself. We're not buying the shares themselves. We are buying the right to buy Intel shares. So if we buy one Intel call option, we'll have the right to buy 100 shares because each option is good for 100 shares. So one call option... 100 shares. Two call options... 200 shares. Five call options... 500 shares. You get it... now let's trade an option...
Let's buy one Intel May 20 call option currently trading for about $1. Let me break this down for you...
We're buying a call option on Intel stock. In this example, Intel is called our "underlying security." So we are buying the right to buy Intel. We're buying one option that gives us the right to buy 100 shares.
We're buying a May option. This is the expiration date. Options exist in every month, and you can buy options as far out as three years. In this example, we're buying a May call option. That means on the third Friday in May (option expiration day), that option expires. So we have between now and option expiration day in May for Intel to go in our direction.
The "20" in our Intel May 20 call option is the "strike price." That's the price that we are agreeing to buy the stock at. We have the right to buy Intel at $20 a share.
So to put it all together, we have the right to buy 100 shares of Intel for $20 a share any time between now and option expiration day in May. And for that right, we're paying $1. Now, that's not just $1 per contract. That's $1 per share. Since each contract covers 100 shares at $1 per share, 100 shares equals $100. So what we're doing here is we're putting up $100 to have the right to buy 100 shares of Intel for $20 a share any time between now and option expiration day in May.
Not too complex. Rather than buying the stock today, buying 100 shares of Intel at $20, and putting up $2,000... we're buying one May 20 call option on Intel. We're putting up $100. The other $1,900 is sitting in the bank earning interest, or whatever you've got working for you. Again, instead of putting up $2,000 to buy the stock, we're putting up $100 to buy the option.
Now, the most you can lose any time you buy an option is whatever you've spent on the option contract. So if Intel doesn't go up and in fact drops, then we're not subject to a $2,000 loss on the shares of Intel. We're subject to losing 100% of our option premium, in this case $100. That's significantly less than what you'd put up for the stock.
This is important to understand. This is where you use options to reduce risk. Rather than putting up $2,000 to buy 100 shares of the stock, you put up $100 to buy control of 100 shares of the stock. It's a big difference – $100 risk versus $2,000. You only buy call options when you expect the underlying security to go up in value. Obviously, if we didn't like Intel at this price – if we thought Intel was going to fall over the next few months – we're not going buy call options on it. We're buying call options because we think Intel is going to go up.
So let's see what happens if Intel does go up. Let's say Intel goes to $22 a share. Remember... we have the right to buy the stock at $20. Now let's fast forward to option expiration day in May. Here we are the third Friday in May, there's no time left to the option... Intel is trading at $22. We own the right to buy it at $20. There's a $2 per share difference there. So the minimum value of this option that we bought, the May 20 call option, is going to be the difference between what we're able to buy the stock at, our strike price, and where the stock is currently trading. So the minimum value of that option is going to be $2.
Now, remember what we paid for it: we paid $1. So here the stock has gone up from $20 to $22. The stock's gone up 10%. Our option has gone from $1, or $100 per contract, to $2 or $200 per contract. We've made 100%.
So keep in mind... you can make 10% on the stock or you can make 100% on the option. You could lose $2,000 owning the stock if the stock goes to zero, or you could lose $100 on the option.
Now, I have to ask you, what do you think makes more sense? Buying the stock or buying the option? Obviously, buying the option. Again, we're reducing our risk and adding a little bit of pop to an otherwise conservative portfolio.
Here's the problem most people have when they trade options and why most people lose... (We'll go through some other examples as well, so if you didn't pick it up the first try it's fine.) Most people look at something like that example with Intel that we just did and they say, "Well, I've got $2,000 to invest. I could buy 100 shares of stock, or I could buy 20 call options."
They take the entire $2,000 nest egg and put it all into the Intel option. So instead of buying one, they buy 20 Intel May 20 calls. They take their entire nest egg, $2,000, and pump it all down into that one option trade. When you do that I promise you something interesting is going to happen. The stock's going nowhere. Any time you over-leverage a trade, you're setting yourself up for a horrible situation. You will wind up losing 100% of everything.
Let me explain. Intel is currently trading at $20. Let's say we get to May expiration and the stock is still trading at $20. It's gone nowhere. You own the right to buy the stock at $20. It's currently trading at $20. There's no difference. On option expiration day in May, that option is going to expire worthless... And you're entire investment is now worthless. So you've lost the entire $2,000. That's the biggest mistake most people make. If there's one thing I have to counsel folks on all the time, it's to not over-leverage a trade. Again, the idea is to reduce risk.
It's wonderful if you were guaranteed Intel was going to go up 10% during that timeframe... of course you'd put all your money into an Intel call option. You're guaranteed to make 100%. But you don't get guarantees in the stock market. You're not guaranteed a stock's going to go up. You're not guaranteed it's going to go down. You're not guaranteed it's going to stay the same. So any time you over-leverage a trade or over-commit too much capital to a position, you are taking on too much risk. You're doing the exact opposite of what options are designed for. (I know a little bit about what I'm saying because I did it.)
I'll tell you a story about my very first option trade. It's what got me passionate about the industry. It's what taught me so many lessons that I've built on over the years...
When I first started trading options, I was 19 years old. I was a sophomore in college. I had just passed my Series 7, the stock broker's licensing test. I was a brand-new rookie broker at a small independent firm out in Oakland, California. And I was a fundamental analyst. I liked the whole Graham and Dodd thing – like Berkshire Hathaway. I liked all those sorts of things that talked about you buy low, you hold on forever, and you sell high. That was my philosophy going in.
Then one day I showed up in the office. A couple of guys were in the back of the room. They were high-fiving each other. They were yapping about some trade they had just made. And they told me they had made 100% overnight. I was curious. I said, "What the heck did you do?" And they showed me a little bit about options.
Now up to that point, the only thing I knew about options was just enough to pass the Series 7 exam and get my stock broker's license. I didn't know anything else. So they showed me a handful of things they were doing with call options. I thought it looked interesting. So I took money out of my little trading account... I had a $5,000 trading account, so I took $600 and bought four S&P 100 index options at $1.50 each. So $150 per contract, bought four of them, put $600 off... Then I went to school – had to go to class.
Six hours later I came back in the final minutes of trading for the day. What I had paid $1.50 for was now trading for $4.50. I had tripled my money. I had a 200% gain. I thought, "Wow, this is kind of fun." So I sold those, made a $1,200 profit in one day... as a college student. That seemed pretty exciting, so I did it again. The next day, I bought IBM options and those went up in value in a couple days. I doubled my money on those in just a couple days. I did it again... This time it was digital equipment. Those options went up in value in a couple of days. And I have to tell you, the first time trading options I went 17 for 17, never lost a trade. Never did less than make 100% on every single option trade I did for the very first 17 trades I ever took. That's pretty exciting.
Now, I never put that much money into anything. It was always somewhere between $500 and $1,000... and every time it was doubling. Over the course of about six weeks, I turned my little $5,000 account into a $50,000 account. Now, that's really exciting.
But something interesting happens when you get that sort of success early on in options trading... and something very interesting happens when you're a 19-year-old college student when you get that sort of success: a little change in personality. So instead of this meek little college student walking into the office and, "Hi everybody." And, "Oh gosh, what is it we're going to do today?" I'd walk in the office and folks would surround me, "What are you trading today?" It was like working into the horse races with the tip sheets.
"Oh geez, what are you trading today? Tell me what you're doing. Mr. Clark, may I take your coat? Here's a cup of coffee, Mr. Clark." Nineteen years old. I thought I could do no wrong. Trade after trade after trade was going in my direction, things were exciting, everybody was loving me. It was wonderful. I never had so much attention paid to me, all sorts of things going my way.
And then there was this one older broker that came over to me one day, a sweet-hearted old guy, and I guess he had noticed a change in my personality. He came over and put his hand on my shoulder and said, "Listen son, you're on a streak, you're on a hot roll, everything's going right for you." He said, "I hope it keeps going. But you know, I've been in the business a long time, the streaks end, things happen. Be careful." I looked him in the eye and I said, "Dale, go pedal your bonds." Like I said, your personality changes.
I got tired of making $500 or $1,000 or $1,500 a trade and I decided, "You know what? I'm so smart at this, I'm going to take everything I have – that entire $50,000 – and I'm going to take the rest of the money I have in the bank – I had about $20,000 in the bank – and I'm going to put it all together. I'm going to buy a handful of options, leave for the weekend, come back, and be done with this whole thing by Tuesday. That's what I did. I bought IBM options. I bought S&P 100 options, digital equipment... I had Sperry Burroughs options at the time, all sorts of different companies out there. Probably 12-13 different options positions. All the money went into that and I went home for the weekend.
It was a couple weeks before Christmas, so I went out shopping for Christmas... Now I'm a very generous person. I was very generous back then because... why not? I had a money-tree growing. So I went out there and bought a television set and a refrigerator for my parents. I bought my brothers gold watches, my girlfriend at the time a nice emerald necklace and an emerald ring. Everything was wonderful. Of course, I didn't pay for any of that cash. I used my American Express card because I needed my cash to make my fortune by Tuesday in the options market.
Nothing much happened between then and the end of the year. Christmas came, everybody opened up their gifts. Oh what a wonderful son, brother, boyfriend, all that sort of stuff. And then the first week in January reality started to set in. The very first trading day of the year in 1984 was a bad day for the market and my options positions probably lost 10% that day. Nothing much, shake it off. Second trading day of the year in 1984, the market fell again and my options positions lost another 10%. All right, nothing to get worried about yet. Third trading day in the market in 1984, bad day for the market... my options positions dropped about 30% that day. Now we're starting to feel a little bit queasy. By the fourth trading day, stocks were down one more time... and everything I had put into the market, every single position I had was halved.
I had put $70,000 into the options market thinking I was going to be rich a couple days later. Well, here it was a couple weeks later and I had lost half the money. I was sick. I was queasy. I didn't even want to go to the office anymore. So I picked up the phone, called the branch manager, and said, "Listen, I'm not going to make it in today, could you give me a quote on the value of the options in my account?"
I got the bad news and I told her, "Listen, just go ahead sell everything." So we sold everything, I went into hibernation, rolled up in the fetal position in the corner of my bedroom thinking what in the world did I just do? And then it dawned on me as the dust settled and everything else happened... The $70,000 I had put in was now worth about $35,000. And then logic, the rational mind starting to think about how do I get out of this? Well, it wasn't too tough because I started with $5,000. I added another $20,000 or $25,000 to the account... so I was into the account for $30,000 and it was worth $35,000. So yay, I had actually made $5,000 over the entire time of my early option career.
I was starting to feel a little bit better. I got off the floor, went outside, checked the mail, and sure enough in the mailbox was my American Express bill – $17,000 in presents for the friends and family.
So my first time option trading was very exciting... went on a wonderful streak, 17 in a row, got greedy, got cocky, forgot what options were originally intended for, took everything I had, put it all out there, and ended up in debt up to my ears. But the one thing I realized about options trading at that time was if you can make money that quickly, and if you can lose money that quickly, options must have a very strong power. And I thought, "Gosh, if I could just figure out how to harness that power and use it for what options are designed for, this could be a fairly lucrative business."
And now here it is 28 years later, and I've done pretty well doing that. The whole idea behind everything we're talking about today is to help you learn that sort of thing.
The first thing you need to learn is not to over-leverage a trade. Understand that options are designed to reduce risk. What I did early on didn't reduce risk. It increased the risk. So what we're going to talk about and spend an awful lot of time doing is not talking about how you can make a fortune buying Intel calls... we're going to talk about how you can reduce risk by buying Intel calls instead of buying Intel stock. And in the process of reducing that risk, you're going to make a little bit of money – add a little bit of pop to an otherwise conservative portfolio.
Let's take a look at another example. Say you like Apple. I can look around the set here and see Apple computers everywhere. Both my kids have iPods, my wife has one of those little iPad things. There's an iPad 2 that's out on the market now. Everything in the world is Apple. Apple is firing on all cylinders, so why not? Maybe Apple goes higher from here. Currently, Apple is trading around $350 a share. It takes $35,000 to buy 100 shares of Apple. I don't know. Not everybody has enough to put into the market and buy 100 shares of Apple. If they do, that's wonderful. But if not, maybe it's not so important to own Apple as it is to control 100 shares of Apple. So let's take a look at what it takes...
You can buy one Apple June 350 call... and those are going for about $20. Again, let me explain how this works. We're buying a call option, so we're buying the right to buy Apple. We're buying one call option, so we're buying the right to buy 100 shares of Apple any time between now and option expiration day in June – that's the third Friday in June – at $350 a share. Apple's currently trading at $350. We're buying the right to buy it at $350. For that right, it's going to cost us $20. That's $20 per share, so a total of $2,000. In other words, instead of putting up $35,000 to buy 100 shares of Apple, we're putting up $2,000 to buy the right to buy 100 shares of Apple.
Let me talk a little bit about this premium that we're paying. This is the money we're putting up to buy the option: it's the "call premium." Any time you buy an option contract, you're paying premium. Premium is calculated in a number of ways. It's really a market supply and demand function. Essentially, it's the same way a stock price is calculated. Apple is trading at $350 a share because in the entire universe of folks who want to buy or sell Apple that seems to be the price where everybody comes together.
Well, the same thing applies in the options market. There's no set price for options but everybody who trades options determines what they are willing to pay for the right to buy Apple at $350 a share between now and option expiration day in June. And between the universes of folks who want to buy it and the folks who want to sell it they've come to $20 roughly. Now, number of days to expiration is a factor. Obviously, if you're going to buy a three-month or a four-month call option, it's more expensive than a one-month call option. If you wanted to buy a call option on Apple that goes out three years, it's going to cost considerably more than what this costs. The price of the stock matters.
Apple is currently trading around $350 a share, which is the strike price of our call option, where we've agreed to buy the stock. If Apple was trading at $340 and we're buying the right to buy it at $350, we probably don't pay so much because the stock would have to move up ten points before we would even be interested in exercising our right to buy. And if Apple was trading at $380 a share we have the right to buy it at $350. Certainly that's going to cost us more than 20 points because we have the right to buy it at $350 and the stock's already trading 30 points higher. So certainly that is taken into account.
Volatility is probably the dominant factor that goes into pricing an option. The more volatile the stock, the higher the probability that option is going to create value, the more expensive that option is going to be. If you have a stock that goes absolutely nowhere – it's been $15 a share for years – the option isn't going to cost much because nobody looks at that and says there's a high probability that stock going to be much higher.
You take a stock like Apple, which can fluctuate seven, eight, nine, 10, 15 points a day – that's very volatile. The option premium is going to be much more expensive. But again, the bottom line is that everybody who's interested in buying or selling options on Apple gets together and they figure out about where the option premium ought to be. You don't have to think anything of this because all you have to do is go over to your computer, punch in the symbol for Apple, punch in whatever options you want to use or trade, and the number comes up and it tells you at the purchase price. You don't have to go into the calculations and everything else. It's already figured out for you.
That is the same way you buy a stock. You don't have to determine Apple is worth $350 or it's worth $340 or it's worth $370. You just know you punch up Apple on your computer, and you see that the stock is trading for $350. Same thing with the option... You punch up the Apple June 350 call options, and you see it's trading for roughly around 20 points.
Now, three things can happen here. Apple can go up, it can go down, or it can stay the same. Let's take a look at it going up...
Between now and June, let's say Apple goes to $400 a share. If you bought Apple at $350 and it's now trading at $400, you made 50 points. You put $35,000 in to buy 100 shares and you've made a $5,000 profit. Congratulations. If you bought the Apple June 350 call option and Apple is trading at $400 on option expiration day in June, then you have the right to buy it at $350. That option is going to be worth at least 50 points. There's no time left, so no trader is going to pay you extra for any extra days. No one is going to pay a higher premium than what the intrinsic value is with the option, but you have the right to buy the stock at $350 and it's currently trading at $400. So that option is going to be worth at least 50.
And remember you paid $20 for it. So you put up $2,000 for the right to buy 100 shares of Apple at $350... And that $2,000 is now worth $5,000. So you've made $3,000 on a $2,000 investment. You made 150%. That's significantly better than making whatever this works out to, 17%, 16% on the stock. Sixteen percent on the stock or 150% on the option... what would you rather own? Obviously, you want to own the option.
If somebody put a gun to your head and said between now and June, Apple's going to go to $400 a share, you could either buy the stock for $350 or you can buy the right to buy the stock and that would cost you $20. You'll either make 17% on the stock or you'll make 150% on the option. Somebody's got a gun to your head, what do you take? Obviously, you're going to go with the option.
The problem is what happens if the stock doesn't do anything? What happens if Apple, which is $350 today, is $350 by the time the option expires in June? If you own the stock, then your $35,000 is still worth $35,000. You haven't lost anything. If you took $35,000 and put all of it into the options market, here we are on option expiration day in June, Apple's at $350 a share, you have the right to buy it at $350 a share. There's no advantage there. Nobody's going to pay you extra for the right to buy the stock at what it's trading for in the market right now. That option's worthless. So you've lost 100% of that position. If you took your entire wad of cash and put it into Apple, you would have lost everything.
That brings up the interesting commandment here. There is a trader's commandment. You know, you've got the Ten Commandments... Traders have 11 commandments. The 11th commandment is "risk not thy whole wad..."
Simply, this means you don't want to put everything into one options trade. If you can buy 100 shares, why not buy one call option... maybe two options if you want to add a little extra "oomph" to the account? Three options is possible... but much more than that, and all of a sudden, the idea of reducing your risk has gone the other way. You've started to increase risk. Again, the idea behind options, the real purpose of options, is to reduce risk. Buy 100 shares or buy one call option, maybe two, all right? If you're really aggressive, you can get away with three... But if you get much more than that, forget it. Odds are going against you, and you're going to increase your risk.
As an options trader, I don't mind if you want to go ahead and throw all of your money into that option. I will take the other side of the trade all day long. But if you really want to make money in the options market, you're not going to try to do it by getting rich overnight. The idea is to consistently profit. If you are not consistently profiting on your option trades, you're doing something wrong... And most likely, you're risking too much on each one. The idea behind everything we're going to go over today, everything that we've put together in this DVD series, is to make sure that you can make consistent profits. You should never have a down year trading options. It shouldn't happen because, again, we're reducing risk and increasing the return.
Let's take a look at the third scenario... Apple's stock declines. Apple, which currently is around $350 a share, drops to $2 a share. I know that sounds crazy, and it's probably not ever going to happen. (By the way, if Apple gets to $2, it's probably a pretty good buy.) But just for our sake, let's say it's $350 today and it's $2 tomorrow. If you own the stock, you put up $35,000 to buy 100 shares. Your $35,000 is now worth $200. That's a pretty significant loss. If you bought the option – remember the option was trading for $20 – that's $2,000. Instead of putting up $35,000 to buy the stock you put up $2,000 for the right to buy the stock.
We get to option expiration day in June and you have the right to buy it at $350. The stock is trading way down here at $2. Nobody's going to buy it from you at $350. You're not going to buy it from anybody at $350. It doesn't make any sense. So that option is worthless. Everything you put into that trade is now gone away. But it's not like you lost $33,000. You lost $2,000. It's never fun to take a loss, but it's going to happen... And if somebody put a gun to your head and says, "Hey, you're either going to lose $33,000 or you're going to lose $2,000... What do you pick?" Well, it doesn't take a genius, right?
Again, that's the point of options: to reduce your risk. There are only three directions a stock can go... it can go up, it can go down, or it can stay the same. If you're buying a call option, you're betting on the fact that that stock is going to go higher. You make money if the stock goes up. You lose money in the other two directions... If the stock goes down or stays the same, you're going to lose the money that you've put into an options trade. So on average, you're going to make money one-third of the time.
Think about that. If you're going to make money one-third of the time and lose money two-thirds of the time, you have to put together some sort of a strategy that allows you to still profit when you're wrong most of the time. It's not that hard to do, actually. It's really just a matter of figuring out where you think that stock could eventually go to on the upside and what you're willing to pay for that option.
In the next installment of this options trading series, we'll talk about selling calls. We'll talk about that next time. Thank you very much. |
