What Makes Trading Options So Special?

By  Wendy Kirkland

 

For today’s discussion, let’s not worry about whether we know for sure that a stock is ready to move up or down. We will just say we know that the stock will report earnings the first of next week. With that knowing, we are interested in trading that equity because we feel it will move up in price after its earnings report. 

Let’s use Salesforce.com (CRM). It is a good mover and is at a price that is easy to multiple.  Its current price is $200 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 the week, its price might be $202, and we will say we have $1,000 we’d like to invest.  This means we could buy 5 shares and spend $1,010.

It does have its earnings report on Monday (in truth, it is May 30th– this is just an example) morning before open and its report is above what was expected and price moves up $5 and continues to rise into the rest of the week, so by Friday, its price is $212.  It looks a little top heavy and because it is a Friday, you decide to sell to take profits.

You bought the 5 shares for $202 and sell for $212, realizing $10 profit per share or a $50 gain over that short 5-day 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 above is an example of an option chain.  We are just using this for our discussion to explain the process (the dates and premiums don’t actually apply to buying, but we will use in our example of closing the trade.) 

On Friday, the day we decide to buy the options, the stock’s price is at $202 and we select the 210 strike because we feel before the expiration date of the option, June 16, price will rise up to $210 or beyond.  The current date is Friday, May 12, so we will have access to the option contracts for a little over a month 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.

Also on this Friday, we pay the Ask of $2.75 for the 210 strike. This totals $275 per contact of 100 shares. We decide to buy 5 contracts for $1,050.  We now benefit from or lose based on 500 shares of CRM. On Monday after earnings, the Ask goes up and it continues to rise until the following Friday when we choose to sell to close the trade.  In sense, what we have done is to rent the stock for a period of time, about a month until June.  That said, we decide to close the trade well ahead of June and stop renting after about a week.  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 above- Bid for 210 strike.)

When we close the trade, we receive $6.05.  Each contract is now valued at $605 because each contract covers 100 shares of stock, and we purchased 5 contracts or a total of $3,025.  We paid $1,050 and sold for $3,025, meaning we gained or earned a profit of $1,975 or 194% gain over those 5 days.

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 5 shares, for about the same investment. (A little more, 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.  Next month we will discuss Put options (options to choose when you expect price to drop.)

My goal is to teach everyday people how to trade options, to learn to read charts, and while they are learning, they can participate 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.

 

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