How to Trade Stocks and Options

For the person who is already familiar with trading in the stock market, and who has been able to make money by trading common stocks, attention may turn to the possibility of trading options where the lure of much bigger gains can be enticing.

The bigger potential gains are accompanied by much greater financial risks. It is accepted in the profession that most non-professional traders lose money in options trading, and a lot of professionals do too. It is best to start with the simpler option strategies of buying calls and puts while the many other more complex strategies can be considered later.

The most important factor is to be able to identify stocks that have a high likelihood of moving up or down in price from their current level, coupled with the ability to forecast within what timespan the move should occur. With options, timing is very important, options gradually lose their value every day until they can expire worthless, as most options do. That is why they are called a wasting asset.

The main advantage of trading options is the substantial leverage they provide and the smaller amount of working capital needed to purchase them compared with the amount of capital to purchase stocks. Both those factors are important to the small trader, the non professional who wishes to participate in a speculative way where the risks are higher but the rewards can be greater.

This article is addressed to the speculator who has already made money in the market, is familiar with how it works and has at least a basic understanding of options – as many do but are hesitant to enter the field. The following paragraphs explain a real life option play that will show what can happen when trading options. This example should encourage further study and investigation into the subject by stock traders.

Following the above comments about trading options, I would like to describe an options play reported in a Forbes online stock market news column that appears to actually have taken place. That may make it more realistic for the beginning trader instead of just inventing a hypothetical trade, although there is nothing wrong with using a hypothetical trade, the results would still be perfectly valid but I hope the added reality aspects would be even more convincing when discussing the benefits from trading options successfully. So here goes, and this is a current play right up to date as I write this.

Today is July 14, 2010 and the following report refers to a purchase last week of options for the stock of CSX Corp, stock ticker symbol CSX. We don’t need to know about CSX Corp, just the options play is what we are interested in and how it will turn out.

Last week, on Tuesday afternoon July 06, 2010, the Forbes news service article commented that at least one investor is ready to profit if the stock price of CSX moved above $51.15 by expiration date on Friday 16, 2010. The investor had purchased approximately 7,500 CSX options. If you wish to verify this report you can find it on the internet at Forbes Markets Channel News on the page for 2010/07/06.

The details are:
July 06, 2010, with the CSX stock trading at $48.01 per share, approximately 7,500 call options for CSX were bought at $1.15 per contract with a strike price of $50 and for July expiration, Friday July 16, 2010.

So let us look at this transaction. We can see it is “Out of the Money” meaning that the $50 strike price is higher than the stock price when the options were purchased. And the options are of short term duration with the expiry just 10 days away. Ignoring the commissions involved, the break-even figure that the stock has to reach is the strike price of $50 plus the $1.15 for the option, that makes it $51.15

What happened after the option purchase
The CSX stock did go up in price after the purchase until yesterday when it reached a high of $53.90 and closed at $51.72.

There is no urgency to sell the option while the price is still rising, but let us use today’s stock and options pricing as if it was actually sold with the transaction being made at 1:47 pm, July 14, 2010 at the exact price quoted by my broker, OptionsXpress.

The CSX stock is trading at this time at $52.51 per share and the $50 strike options are quoted as bid 2.61 asked 2.68. So for the purpose of this trade example let us say the options are now sold at 2.60 just below the bid price at the time. Now we can calculate the results.

Cost of option @ 1.15 Sold at 2.60 = + 1.45 = + 226 % A great trade and a great gain in 10 days.

Compare with the gain in sale of the stock only: Cost per share $48.01 Sold at 52.51 = + 4.50 = + 09 %.

In conclusion
The type of option trade described above is not recommended for the beginner, the purchase date is too near to the expiry date and the beginner should buy options that have several months to go until expiry. With a successful longer-term options trade, the same type of percentage gain can be achieved and often many times as much.

Not all option trades turn out successfully and the above transaction carries a high level of risk but it does indicate the power of leverage where a $1.15 option can provide a 226 percent gain compared with the 9 percent gain from buying a share of stock at $48.01. However, in the case of a purchase of the stock instead of the options, it would not be likely that a sale of the shares would have been made at this time. The share buyer would normally have a long-term outlook and objective, looking for the company to do well and prosper over time and appreciate in significantly in value while providing a less risky investment. But requiring a much greater capital investment of course.

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A basic profitable strategy

There are dozens, of ways for trading options, some of them very complex, but we want to start with an effective basic strategy that can be shown to be profitable, easy to follow, and easy to implement.

There are just four “rules”, listed at the end of this piece that provide a simple way to trade options, a field where strategies of varying complexity and risk for trading are numerous.

If you can pick winning stocks, those that go up in price, you can do very well trading the options for such stocks.

The key is whether a chosen stock performs up to expectations by rising in price in the case of a call option, or falling in price in the case of a put option, and doing so within the span of time before the option expires.

Time is the important factor
If the underlying stock does not perform as expected, the option should to be sold on or before a specific pre-set target date. That would mean a loss if there has been no gain at all in the price of the stock and maybe a loss even if it has gained, those possibilities should become clearer as we identify the guidelines later. Reference will be made below to a pre-set “sell by” date.

Loss and gain
With most options, the maximum dollar loss that can occur is the fixed amount of the purchase price paid, whether the option position cost $500 or $5000, that is the most that can be lost if the option is held until the expiration date when it automatically becomes worthless. But the guidelines below establish a fixed date prior to the expiration date of the option, which may allow a smaller loss.

It should be understood, that in this type of speculation, with a series of sensible trades there will probably be some losses, what is important is that a risk management plan is followed that can minimize those losses as much as possible and preserve working capital. Obviously there must be more winners than losers to stay in the game and provide sufficient reward to compensate for the risks involved. There should also be a strategy to maximize gains when they occur, in other words, to not exit a position too soon.

The right stock for the right time
In the same way that any other stock purchase is made, the choice of stock to trade should be made after what is usually termed as “due diligence”, appropriate research in checking out the attributes and prospects of any selected list of stocks. Whether after a short or long appraisal, or for whatever reason, we must assume that a promising candidate has been chosen to make a trade in options using the simple strategy outlined here.

For stocks, or indexes, or for other optionable financial vehicles, there are normally many different options available, offered at different strike prices and for different terms (lengths of time in which the option can be exercised).

As an example, let us assume a decision is made to buy calls. To make the option trade we need to specify the following, the first requirement is fixed, based on the stock chosen after suitable research.

1. name and symbol of the underlying stock (or index)

2. strike price

3. expiration date of the option

Those last two requirements provide a myriad of alternatives. There are many strategies followed in option trading that determine the specifics of the above and the risks attached to those strategies differ. Option trading promises bigger gains but the risks are higher.

Buying a Call, guidelines for a simple option trade:
Avoiding the option strategies of highest risk, the suggested guidelines for a basic call option trade establishes specifics for the strike price and term as follows:

1. The strike price will be “in the money”, at a price below the current price at which the stock is trading. How far below? The delta value noted below can help to determine that. The deeper into the money, the higher will be the option price.

2. The expiration date will be approximately 4 to 6 months after date of purchase

An explanation of why it is “approximately”:

Option contracts expire during different months according to a pre-determined calendar and vary for different companies. The day of expiry is always effectively the third Friday of the month (although it is actually the third Saturday of the month, but there is no trading on Saturdays.) The farther away the expiration date for a given strike price, the higher the option price will be, that’s because more time is being bought. But usually when an option is sold with a month to go before expiration, it should have some dollar value left in it because of the one month of remaining time whereas it will be worth much less the nearer it gets to the expiry date.

3. Important Note: the position will be sold no later than one month before the expiration date. Always. Depending on performance (we) may just exit or we may “roll up” to a later expiration date.

4. Delta, An additional guideline
Explained elsewhere on this site, the delta is a numerical value that varies dependent on the changing price of the underlying stock. It is a useful guide in tracking the stock’s progress and to assess the potential for gain as a stock moves in price.

Choose an option with delta of about 60 to 65

In our next post, to better explain the foregoing, we will provide more details and specific examples to show how the leverage provided by a successful option trade gives a bigger bang for a buck.

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