What is the Benefit of Option Trading?

What is the Benefit of Option Trading?

By – Wendy Kirkland

For now, let’s not worry about whether we know for sure that a stock is ready to move up or down, for today’s discussion, we’ll say we know that the stock will report earnings tomorrow. With that knowing, we are interested in trading that equity because we feel it will move up in price after its earnings report.  For the purpose of this discussion, let’s pick an equity, any equity, it doesn’t matter.

Let’s use Salesforce.com (CRM) and let’s go back in time to its last earnings report on November 29th.  It is a good mover and is at a price that is easy to multiple.  On November 28th, the day before earnings, its price is about $225 per share.  So, as we mentioned, let’s say that we’d like to purchase shares of Salesforce.com (CRM) because we feel it will have a positive earnings report and will move up in price.  Likely by the end of next month- December, its price might be $250, and we will say we have $1,000 we’d like to invest.  This means we could buy 4 shares and spend $1,000.

It does have its earnings report on Wednesday (November 29th- this is just an example) morning before open and its report is above what was expected and price moves up $3 and continues to rise into December, so by December 22nd before Christmas, its price is $266.  It looks a little top heavy and because it is close to Christmas and the end of the year, you decide to sell to take profits.

You bought the 4 shares for $225 and sell for $266, realizing $41 profit per share or a $164 gain over the month period.  No real physical effort, just buy and then sell the stock.

Let’s compare the same stock and price movement, but let’s apply it to stock options.  I think of option trading as renting equities for a specific period of time.  On a brokerage’s website, they have option chains listed.  Chains list the prices of the options (Ask is what you normally pay to buy a specific strike option and Bid is what you normally receive when you sell.)

The image below is an example of an option chain.  We are just using this for our discussion to explain the process (the dates and premiums apply to buying on November 28th, that we’ll use in our example of buying and closing the trade.)

On Tuesday, November 28th, the day we decide to buy the options, the stock’s price is at $225 and we select the 250 strike because we feel before the expiration date of the option on January 19th, price will rise up to $250 or beyond.  The current date is November 28th, so we will have access to the option contracts for a little over a month and a half and will benefit from price gains or lose value for as long as we hold during that time. We can sell anytime during that period.

On November 28th, we pay the Ask of $1.93 for the 250 strike. This totals $193 per contact of 100 shares. We decide to buy 5 contracts for $965.  We now benefit from or lose based on 500 shares of CRM. On Wednesday after earnings, the Ask goes up and it continues to rise until the holiday period when we choose to sell to close the trade on December 22nd. In sense, what we have done is to rent the stock for a period of time, about a month and a half until January if we were to held until it expires.  That said, we decide to close the trade well ahead of January and stop renting after about a month.  When we close the option trade, it still has some time value as well as price value. We receive the current Bid price (the difference between the Ask/Bid is like commission to the one handling the trade/rental.)  (See chain below- Bid for 250 strike.)

When we close the trade, we receive $18.40.  Each contract is now valued at $1,840 because each contract covers 100 shares of stock, and we purchased 5 contracts or a total of $9,200.  We paid $965 and sold for $9,200, meaning we gained or earned a profit of $8,235 or 853% gain over that month period.

This example shares the benefit of trading options or renting stocks for a specific period of time.  When you buy a share of stock, you own it until you sell. There is no time limit. You could hold it for years.  When you trade options, you select and pay for an expiration date.  It could be a day, a week, months or years.  The more time, the more expensive.  Once you learn to interpret charts and their patterns, you then decide based on some factor (earnings, news, chart patterns), what strike to select, Ask premium to pay and what you expect to happen during that time-span.  When it happens, you sell to close the trade. If the move doesn’t happen, you close to protect from a large loss.

Trading options provides leverage. In our example, 5-contracts means you benefited from the price move of 500-shares of Salesforce.com, not just 4 shares, for about the same investment. (A little less, but close.)

Again, option trading is like renting equities for a specific period of time, so the next step is to learn how to interpret charts so you know what is likely to happen next with price, so you can jump in.

Another unusual aspect of option trading is that you can earn money on an equity’s price move even if it drops in value by buying Put options.

My goal is to teach everyday people how to trade options, to learn to read charts, and while they are learning, they can participte in a program like ALPHA that trades the daily charts of equities like Slesforce.com (CRM).  I think of this as an earn-while-you-learn program that is perfectly suited for people who are interested in learning to trade options as well as have the opportunity to earn a profit as part of the learning process.

Have a terrific weekend.

 

Leave a Comment

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.