There are two basic components of options trading: calls and puts.
Both, at some capacity, are the foundation of every single options strategy in existence. And depending on the strategy you decide to use, you can either buy or sell an option.
Let’s start with calls.
When you buy a call, you are giving the buyer of the call the right (but not the obligation) to buy a specific stock at a specific price per share within a specific time frame. An easy way to remember what buying a call means is you have the right to “call” the stock away from somebody.
That’s the textbook definition. Most investors buy calls, most frequently out-of-the-money calls in hopes the stock will push higher. At some point, if the price of the option is higher than the original purchase price of the call, most investors will take their profits and move on.
I like to think about calls, particularly when buying them (which I rarely do, I’ll explain shortly), as a leveraged alternative to buying the actual stock. Remember, 100 shares of stock is equivalent to 1 options contract, so buying 1 call basically means you are in control of 100 shares of stock. The only difference is that an options contract has a finite life and the price of the option decays as it gets closer to its expiration.
The defined duration or life of the options contract means that the underlying stock must move higher to make up for the lost time decay in the option. And this is why I almost always sell options. I want to use this time decay to my advantage.
Let me explain using a brief example.
Below is the options chain for the S&P 500 ETF (SPY).
SPY is currently trading for roughly $195, so anything above $195 would be considered out-of-the-money.
Again, most investors buy options, certainly an inferior way to play options, but I’ll get to that later.
So, if most investors are buying out-of-the-money options, they would start at $196 and move higher. Typically, the industry shows a trend of investors buying options with a 33% chance of success. The 198 strike would qualify as it has a Prob. ITM of 32.58%…close enough.
By purchasing the 198 calls in November with 29 days left until expiration, an investor will pay the ask price of $1.59 per call contract (as seen in the chart below).
So, from the onset, unknowing to most investors who buy options, they only have a 32.58% chance of success. Basically, SPY, which is currently trading for $195 would have to travel above $198 by expiration.
Well, as a seller of options, and one who uses statistics as the foundation for all of my trading, I always want the probabilities on my side. So I have no problem selling calls to someone willing to take a 32.58% chance they will be right about their directional trade. I don’t have to worry about decay. I really don’t have to worry about anything other than if the underlying stock closes below the $198 strike. So, the underlying stock could move as high as $197.99, trade sideways, or move lower and I will make a profit. My chance of success . . . 67.42%.
If you sell a call, you have the obligation to sell the stock or ETF at a specific price (strike price) per share within a specific time frame (expiration date) if the call buyer decides to invoke the right to buy the stock at that price.
The great thing about selling options is that I can choose whatever strike I wish to fit my risk/reward profile.
I prefer to go with a probability of success or Prob.OTM higher than 75%, in most cases above 80%.
I know this is a lot to grasp. Options aren’t easy, which is why they are typically reserved for the mathematically inclined. But this is where investing is headed and if you don’t take the time to learn about how to use options on a basic level, you are limiting yourself to a portfolio that relies on the market moving higher. Everyone can grasp this information. If you are truly interested in learning how to use options to your advantage then please do not hesitate to email me. I will make sure that you are on the right track and more importantly, comfortable using sound options strategies.
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