Profit Strategy: Trading Stock Options With Defined Risk
Stock options lose value over time and that can be used in your favor by reversing the logic. I’ll show you how to put the odds in your favor by reversing the logic and by defining your risk.
Let's first understand why options tend to lose value:
- When you buy an option you are actually placing a bet that the underlying stock will reach or exceed a certain price by a certain date.
- If it fails to reach that goal by the date you specified, it expires worthless.
So it has a time premium added to it when you buy it. As it gets closer to the expiration date, the time premium erodes and the option loses value.
When you buy options on a stock, the stock has to move in the right direction and move far enough in time for you to make any money.
How to Make the Odds in Your Favor
The eroding time premium works in your favor when you reverse the logic. Instead of buying options, you sell them. You become the option writer. Any stock/option broker will allow you to do this.
Writing an option is the term used for selling an option you don’t own. It's also known as selling short. You basically are creating the option. Which is why we refer to it as writing options.
How do you write an option? You sell it in your broker account just like you buy or sell stocks. But when you write an option, you indicate an order to “sell to open”. This is because you are opening a transaction.
When I try to explain this to some people, they say they never knew you can sell something you don't own. It's simply doing the trade backwards and it's the trick with putting the odds in your favor with options.
Someday you will have to buy it back to close the deal. That’s done with a “buy to close” order. But you don't always have to buy it back. If the underlying stock never goes past your strike price (we all that in-the-money), then the option expires worthless and you don't really need to buy it back. You just keep all the money you got for it.
But what if it is close to the strike price and you still have time left before expiration? Remember how I said that most options lose value over time? Well, you can buy it back for less than you sold it for, and you keep the difference as your profit.
What Are You Really Selling When You Sell Options?
There are two kinds of options. A PUT and a CALL:
- When you sell a CALL you are selling someone the right to buy the underlying stock from you at a specific price by a specific date.
- When you sell a PUT you are selling someone the right to sell his or her owned stock to you at a specific price by a specific date.
Options can have expiration dates from one week to several years.
I like to write 30-day options. The time premium erodes quickly in the last 30 days, and that works in your favor when you sell short.
How it Works when You Already Have the Stock
If you already own a stock and you don’t think it’s going to move much in the next 30 days, but you don’t really want to sell it, you can squeeze some extra money out of it by selling someone else a CALL option on that stock. That is, you are selling him or her the right to “call” the stock away from you at the agreed price. Ah! Now you know why it’s referred to as a CALL option.
If the stock drops or stays the same for 30 days, the option expires worthless and you keep all the money you got for the option.
I know what you're thinking... “But I lost money on the stock.”
Remember that you do this with a stock that you really don’t want to sell. So now you still have the stock and you also have some extra money from the expired call option to make up for the lower price on the stock.
When You Don’t Have the Stock but Would Not Mind Owning It
What if you don’t have a stock and you think you would like to buy it, but you are not sure what it will do.
In that case you can sell a PUT option. This means that you are selling someone the right to sell you his or her stock at an agreed price. If the stock goes down below the agreed price within the 30-day period, they can “put” their shares of the stock to you and you are forced to buy it at the agreed price.
But if the stock goes up in that 30-day period, they can sell it on the open market for more. So they would never exercise their option. They would just let it expire worthless and you keep all of the premium they paid you for the option.
What Can Go Wrong With CALL Options?
Now. In the case where you sold (wrote) a CALL option on the shares you own...
What if the stock goes up over the price you said you’d let the other person have it for. Well, in that case they will “call” the stock away from you at the agreed price.
You are forced to sell your stock at that price. But isn’t that a good price? It’s higher than it was 30 days ago. Plus you get to keep the premium you received for the option too.
The really bad thing that can happen is that the stock shoots really high and you are forced to sell it that that agreed price. You lost out on that tremendous gain. You still have the gain you expected plus the money from the option, but you lost out on the huge gain on the stock.
That's another reason for selling option that expire in 30 days. The chances are slimmer for a stock to make a huge move upward in such as short time. But it happens.
What Can Go Wrong With PUT Options?
In the case where you sold (wrote) a PUT option...
Remember that you are doing this under the condition that you would like to buy the stock.
You don’t ever want to sell a PUT option if you are not willing, or able, to buy the stock. I'll tell you why.
If the stock goes down, then the buyer of the option will sell you their stock at the agreed price. That price is higher than it's selling for on the market, and you have to buy it anyway.
This is why I said to only sell PUT options when you want to buy the stock anyway. You may end up buying the stock if you are wrong with the timing or the price.
It's not really a bad thing because even if this is the case, you are still buying the stock at a lower price than if you had just bought it when you first thought about buying it.
Why is that? Because the PUT option you sold was an offer to buy the stock at a price that is lower than it was when you sold the option. That is, you made an agreement to buy the stock at that price in case the stock goes below that strike price by the expiration date.
So you bought the stock at a better price, plus you got to keep the extra premium you received for the option. So in effect, you paid that much less for the stock.
What's the worst case? If the stock goes really low, you are still buying it at that agreed price. That's not such a great deal, because it is worth so much less on the market. But then again, you did this only in the case where you wanted to buy the stock anyway.
How to Define Your Risk
As I mentioned above, things can go wrong. Especially if you are not on top of things and if you are not managing your trades when you see things changing against you.
It is true that options lose their premium value over time. And now you know how to make this work in your favor. But there is a way to improve your success even further. You can define your risk.
Note that so far I showed you how to sell puts or calls and wait for the premium value to erode. But your risk is still the cost of the underlying stock in the case where it goes in-the-money by crossing the options strike price.
If a put option you sold goes in-the-money, the stock may be PUT to you. That means you have to buy it at the strike (agreed) price.
If a call option you sold goes in-the-money, the stock may be called away from you. This is usually fine if you own the stock. You probably sold an option offering a higher price anyway, and you sell the stock at a profit PLUS keep the premium you got for the option.
But if you don't own the stock, you have to buy it at the higher price in order to sell it at the lower price. That's not a good thing.
So what to do? You can define your risk by buying further out-of-the-money options.
Say you decide to sell a call option to sell XYZ at $50. You can buy a call option to buy the same stock at $60. You will pay less for the $60 call than what you got for the $50 call, so you have a credit on the trade. And what this does is -- it locks you into a total risk of the difference between the two strike prices.
No matter how high the underlying stock goes, you can always exercise your right to buy it at $60. You still have to sell it at $50 if it went over that. But $10 is your total risk.
Success by Terminating the Deal Before Expiration
You don't need to wait for options to expire. You can buy them back at any time to terminate your contract to buy or sell the stock.
If you see it going against you before the 30 days are up, and you change your mind about buying or selling the stock, you can close out the deal by buying back the option.
Since options lose value as they approach expiration, you may still end up buying back the option at a lower price even if the stock started going against you.
This means you can get out of the deal and still make some a nice profit. But there's no guarantee of having that opportunity. This usually happens only when the stock moves against you by just a little.
As you can see, you can have the odds in your favor by selling options rather than buying them. It's just important to understand the entire process and know how to manage your trades. Hopefully I have given you some clues on how this is done.
The strategy I discuss here is for educational purposes only and I am not making any recommendations. I assume no legal responsibility or liability for the methods described in this article. You should consult a professional to help you with your investment strategies, and you are solely responsible for your own investment decisions.
© 2012 Glenn Stok