Option trading is ideal for investors who want to invest a small amount of capital, have the potential for relatively large gains, and are willing to accept the chance that some options will not be profitable because the stock price does not change by the desired amount within the chosen time interval.
For all selections, we provide the closing stock price, the recommended strike price and option duration, and the maximum price you should pay for the option.
We also recommend when the option should be sold, either for a profit or to minimize a loss.
If you purchase an option, you should follow the market very closely as the time for a profitable trade is often very short.
ADVANTAGES OF OPTION TRADING
Cost: an option costs much less the amount of money needed to buy the stock outright. A typical option premium is <10% of the price of the underlying stock.
Leverage: A successful option should give a much larger percentage profit than would be achieved with buying and selling the underlying stock
Risk: If an option trade is unsuccessful, the maximum loss is the cost of the option premium. The maximum loss when buying a stock is potentially much higher as a company could fail and the stock become worthless.
Profit from a drop in stock price: Stocks can become overvalued and the price falls. PUT options are a much, much safer way of profiting from this price drop than short-selling a stock.
DISADVANTAGE OF OPTION TRADING
Time Decay: An option expires worthless if it is not exercised within a certain period of time after purchase. Successful option trading requires an investor to correctly predict both the amount a stock price will change and the speed at which the change will occur.
BASIC PRINCIPLES OF OPTIONS TRADING
An option is the right to buy a stock at a specified price (STRIKE price) within a certain time interval, typically a few months. The date at which the option no longer has value is termed the EXPIRY date and is usually the third Friday of each month.
As with all markets, there are buyers and sellers of options. A buyer believes that the stock price will change a certain amount within a specified time interval. A seller believes that this price change will not happen.
A CALL option is purchased if you expect the value of the stock to increase.
A PUT option is purchased if you expect the value of the stock to decrease.
The value of an option is composed of two components: intrinsic value + time value. This is shown in the following examples.
Intrinsic value = Stock price – Strike price (CALL option)
Strike price – Stock price (PUT option)
HOW IT WORKS:
Suppose stock XYZ is trading at $100, you expect the price to increase, and you buy a CALL option. The cost of the option will depend in part on the strike price that you choose. If you choose a strike price of $95, you could use the option to buy the stock at $95 (when it was trading on at $100 on the market). Since this would result in an immediate $5 profit (buy stock for $95 and sell on the market for $100), you would need to pay at least $5 to purchase the option. The option has an intrinsic value of $5. If the strike price was $90, the intrinsic value is $10. If the strike price was $100 or higher, the intrinsic value is zero.
The intrinsic value of a PUT option works in the opposite direction. XYZ is trading at $100, you expect the price to drop and you buy a PUT option. If you choose a strike price of $105, you could use the option to buy the stock at $100 (where it is trading) and sell it for $105. This again would result in an immediate $5 profit so you would need to pay at least $5 to purchase the option and the option has an intrinsic value of $5. A strike price of $110 would have an intrinsic value of $10. A strike price of $100 or lower would have no intrinsic value.
A strike price that is around the current stock price is called an At-the-money option, a strike price that has intrinsic value is called an In-the-money option, and a strike price that has no intrinsic value is called an Out-of-the money option.
An option price has a component called the Time Value. The concept is that the longer the time to expiration, the higher the chance that the stock price will change by the desired amount: a stock price is more likely to change in 6 months than in 1 month. The time value (and therefore the option price) increases with longer times to expiration. Once the option is purchased, the time value (and therefore option price) starts decreasing as the time to expiration draws closer.
Option price = intrinsic value + time value
The option price changes along with the price of the underlying stock. Typically, a $1 dollar change in the stock price causes around a $0.50 change in the option value. The exact value is called delta (∆) and is found in option tables.
The time value decays (and the option price drops) as the time to expiration gets closer. The rate of decay is called theta (θ) and this increases with time, with the decay becoming very rapid in the month before expiration.
Stock Wealth Safely Strategy
While there are many types of option trades, Stock Wealth Safely only recommends buying PUT or CALL options when a sufficient price change is expected and then selling the option when the price change has occurred. More PUTs are selected than CALLs since PUT options are the only safe way to profit from an expected drop in stock price.
We select stocks whose price we believe is likely to change by 3% within 6 weeks of purchasing the option. When the stock price has changed by 3%, we recommend selling the option for a profit rather than waiting for the price to change more. In general, if the price has not changed by 3% within 6 weeks, it is unlikely to do so over the next few weeks and it is better to sell the option to receive some money back from the time value in the option price.
Stock Wealth Safely selections may add value to your investment returns.