Category Archives: How To Trade Options

Stock Market Index Options

Where can a trader find options on the stock market indexes or indices? For a stock the options are connected to that stock and can usually be found very easily. For an index it is only confusing because a traders has many options (no pun intended).

The S&P 500, the FTSE, MICEX, Dax or the Tadawul  are a indexes that traders cannot trade directly. The way the index is trades is via a futures contract or an ETF.

The ETF for the S&P 500 Index is ticker: SPY. The SPY ETF trades in perfect correlation to the actual S&P 500. So when a trader would like to “buy a call on the S&P” or “buy a put on the S&P”, the way it is done is by buying a put or call option on the SPY.  As traders can see in the picture below, there are more options listed for the SPY than any other stock or etf.

Index Options Chain

The other option or method to buy options on the index is via the futures contracts. The S&P 500 futures contract trades on the CME (Chicago Mercantile Exchange) under the ticker ES. They are also referred to as the EMini’s. There are options listed on the S&P futures and they are similar to those traded on the SPY ETF.

A trader needs to look out for the option multiples and option expiration dates and types when using Futures Options.

Another way to trade options on the Indexes is with Binary Options. There are binary option brokers that offer short term options on many of the large stock market indexes. Although binaries are different than weekly options or monthly options they are very easy to understand.

Covered Call Option Trading Strategy

So is a covered call a worthwhile trade?

If you are like me and every time you buy stock it goes down. Then the covered call is a very good trade. Buy the stock, immediately sell a call against it. The stock goes down, and along with it the call option starts declining in value. Now at least there is some profit to go along with the loss.

If we go with the false assumption that the stock market will return on average 8% a year, doing a covered call that returns 1% a month will beat the market and do 12% a year.

Options As A Strategic InvestmentLearning to trade the covered call is not very difficult. Take a look at Microsoft stock ticker $MSFT as an example of buying and selling a covered call.

The covered call trade strategy (aka buy-write) involves buying the stock and selling one call option against every one hundred shares that is owned.

If we were to buy 100 shares of stock in Microsoft, Ticker MSFT for $25.80 a share and then sell the $26 call. This would be a covered call.

Let’s dig deeper and see what just happened.

In the picture below we have the option chain for Microsoft. The example shows the front month options that will expire in 26 days.

Covered Call Options Sample Trade

It is July 26th and we own stock in Microsoft, which we paid $25.80 a share, what can we do to make money on it besides waiting for the stock to go up? We can sell a call.

A call option gives the buyer the right to buy the stock from us on option expiration day. The call option also gives the seller the obligation to sell the buyer the stock for the predetermined price.

If we look at the $26 call, it is trading at $0.50 – $0.53 per contract. This amounts to $50 per one hundred shares. If we sell the $26 call and on options expiration day Microsoft stock is still below $26 a share we get to keep the $50 from selling the call and the stock stays in our account.

If the stock is trading above $26, say $26.10, on option expiration day, the stock will be sold from our account for $26.00 a share and we will keep the $0.50 from selling the option contract. Either way we will have made a 2% profit in one month! If we manage to do this every single month it would be 24% profit on the year.

This sounds very exciting and enticing, but there are downsides to selling covered calls.

One downside to the covered call trade can happen when the stock losses too much of its value and then the profit from selling the call doesn’t cover the losses from the stock itself.

Example: We sold the $26 call for $0.50. We bought the stock for $25.80. On expiration day the stock is now at $25.05. We will have made 2% on the calls but lost 3% on the stock.

OK, so we are only down 1% overall on expiration day, let’s do it again and sell the $26 call for the next month.

Another negative to the covered call trade is when a call is sold and then the stock far surpasses the strike price and now the profit was limited.

Example: We sold the $26 call for $0.50. We bought the stock for $25.80. On expiration day the stock is now at $27.00. We will have made $0.20 on the stock, $0.50 on the options we sold and the other $0.50 that we could have made, is now the profit of the person who bought the option.

Buying & Selling the option

When you are creating a covered call trade, it can be done at one time by placing a combination trade. A combination trade is when the stock it bought and the call is sold simultaneously.  Or, if you already own the stock you can sell a call, either the weekly option or the option that expires in six months from now. Selling a call against stock you own is called sell to open (just like short selling). Some brokers have two different order types for selling options and you will need to select “sell to open”. To buy it back you will “buy to close”.

Do I need to wait for the option to expire?

No. You can go back and buy the option you sold, either for a profit or loss. Sometimes people will sell the call that expires in this month and then the stock has an earnings announcement and the volatility of the option drops giving them a profit on the far out of the money call that they sold. They can lock in profits by placing a “buy to cover” order on the call and sell another call that expires next week or next month.

Put Options Trading

Profiting When The Stock Market Falls

Why does every investor feel bad when the news announcer tells us that the S&P 500 fell 1% today? Why do investors assume that their portfolio lost 1%? The reason is, most mutual funds and stocks do the same thing the S&P 500 does. When the market falls, so does the value of most portfolios.

Except! Protected Portfolios, and day traders with ADHD who trade binary options and profit or lose from 60 second markets movements. Read related article here.

What is a protected portfolio? Also know as a hedged portfolio? The way to protect a portfolio from a stock market crash or correction is with a put option.

A put option is used in two ways:

  1. Investors or traders will buy a put option because they think the price of a stock will go down, and they would like to profit from the fall.
  2. Put options can protect a stock investment like an insurance policy for the portfolio. It give the owner the option to sell the stock at the strike price.

The way an investor hedges an entire portfolio works like this. The S&P 500 or easier to use is ticker $SPY is trading at $178. The December 2014 put option for the $160 strike price is $6.00. This means that if the SPY falls below $160 by December 2014, the owner of the put option can sell shares of $SPY for $160, even though the price may be at $140.

Put Options Trading

The reason no one likes this method. The cost to protect the portfolio is 3.3% and that only offers protection of a loss greater than 10%. So all the put option does for the investor is protect in the event that the markets fall 13% in 2014.

Another way to profit from the fall of the stock market is to trade options. Trading options consists of buying put options in anticipation of the market moving lower. When the market moves lower, the price of the put option usually will go up.

Read our article about trading a covered call.

How To Trade Options – Beginners Guide

There are many aspects to trading options and it can be extremely confusing for someone starting out. Just understanding the option terminology is difficult. Remember, a put option is the right to sell the stock at the strike price, and a call option is the right to buy the stock at the strike price!

Before someone starts trading options they should really know how to trade stocks. They need to be familiar with both buying and shorting stocks. If your friend told you that he turned $1000 into $10,000 and that is the reason you want to trade options, then you are better off in Las Vegas.

Options prices are displayed as the price for one share, even though the contract is for 100 shares. The means, that even though the price says $1.50, if you were to purchase one options contract then you will be paying $150.00. When it comes to selling options, like a covered call, each option that is sold is connected to 100 shares. If you would like to buy $1500 of options, do not place an order for 1000 contracts, you should place an order for 10 contracts.

The various whole dollar prices that are listed are called strike prices. A $30 stock will show prices at $1 – $5 increments from $10 till $50. Depending on the stock depends on how many strike prices will be listed. See picture below.

Some brokers unintentionally make purchasing options a little more confusing. Although they trade like a stock, to actually buy an option, a trader to needs to specify more information. Like “buy to open” versus “buy to close”. Buy to open means you want to buy the option contract. Buy to close, is the order that is placed when the option was sold short and now the trader wants to buy it back.

Call Options

The owner of a call has the right (not the obligation) to buy 100 shares of the underlying stock at the strike price.

For example: Today is January 2nd. XYZ stock is trading at $30 a share. The $30 January call option shows a price of $1.50. If I were to purchase the January $30 call for $1.50, then on the third Friday of January, I have the right to “exercise my option” and buy the stock for $30 a share, even if the stock is at $50 a share!

(If the stock is at $50 a share, then the option will be trading at $20 per contract and you don’t have to wait until expiration day to buy the stock for $30 and then sell it for $50, you can just sell the option and pat yourself on the back for making 13 times your money!)

During the month the price of the option will fluctuate based on the price of the stock. If the price of the stock goes up, the price of the call option will go up too. If the price of the stock goes down, the price of the call option will go down too.

The reason a person buys a call is because they believe that the price of the stock will go higher.

Put Options

The owner of a put has the right (not the obligation) to sell 100 shares of the underlying stock at the strike price.

For example:  Today is January 2nd. XYZ stock is trading at $30 a share. The $30 January put option shows a price of $1.50. If I were to purchase the January $30 put for $1.50, then on the third Friday of January, I have the right to “exercise my option” and sell the stock for $30 a share, even if the stock is at $15 a share!

During the month the price of the option will flucuate based on the price of the stock. If the price of the stock goes down, the price of the put option will go up too. If the price of the stock goes up, the price of the put option will go down.

One reason a person buys a put options is because either they think the price of the stock will go down and they would like to profit from the fall in the stock prices.

The other reason people buy put options is to protect their stock investment. A put option is an insurance policy for your stock. How many times have we bought a stock and over night it drops 20%. If we had owned a put option then we could have limited our loses by having the right to sell the stock at the strike price, even though it is much lower.

This is just the beginning of trading options. View other option trading articles here.


bp

Covered Call Returns 5% a Month

A covered call is an option combination trade which involves buying the stock, and selling a call against that stock.

One purpose of a covered call is to earn extra income and enhance the return on the stock. The downside to a covered call is that your profit potential is limited. The good thing about a covered call is that it can be done every month, and with weekly options it can be done every week!

BP’s stock dropped 50% during May & June, because of the oil spill in the Gulf of Mexico. The story is not over yet, besides the actual damage that was caused, there is still unknown future damages which they may be liable for.

Many investors are now holding onto stock that they paid $50 a share for and it is now trading at $38.50. Naturally, these same traders didn’t sell the stock as it was tanking because that is just human nature not to set a stop loss order.

Where will the stock go from here?

Personally, I do not think the stock is going anywhere too far in the next few months. Maybe 10% up or 10% down but it will probably stay in the $35 – $40 a share range.

I will try to buy the stock and start selling call options, either the weekly or monthly options against it.

Based on Friday’s closing prices the stock was at $38.47. I can either sell the Aug 6th $39 call for $0.67 or I can sell the Aug 21st $40 call for $1.00.

Assuming we buy 100 share of the stock for $38.50 a piece and then sell the $40 August 21st call for $1.00 that gives us a total cost of $3750. (The stock cost $3850, minus the premium of $100 received from the sale of the $40 call.)

If the stock closes above $40 a share on August 21st then we will make a maximum profit of $250. If the stock is at $39 a share on August 21st then we will have made a profit of $100 from the $40 call expiring worthless and we still have the stock that we paid $38.50 a share. If the stock is still at $38.50 a share, then the option we sold will expire worthless and we will have made $100. About 2.5% return in three weeks!

The ideal scenario is for the stock to finish trading as close to the strike price at expiration. After expiration, we will then have the opportunity to sell a new call option against our stock. Sometimes the stock will shoot higher than the strike price of the option we sold, and this means that on option expiration day we will be forced to sell our shares to the owner of the call option. They refer to this as having the shares called away from you.

This article was originally published on August 1st 2010, The truth always endures!