Let’s look at the options
Mention stock trading to most traders and their first thoughts are of trading in the cash markets using a buy and hold long term strategy, which is perhaps the place that many of us start in the financial markets.
This after all is the market which is widely reported every day in the mainstream financial press. The one minute sound bite updates us on the principle indices for the UK and US markets, and that’s really all we ever hear. Most people therefore mistakenly believe that the long term buy and hold strategy is the only one when considering the options for trading stocks. However there are many, many more. Buy and Hold is just one and is generally followed by investors who are looking for longer term returns either from capital growth in the underlying stock, or for income from dividends.
For speculative traders the choice of strategies and instruments is bewildering, but whichever you decide to adopt, this will partly be determined by your approach to the market. Are you a speculative trader looking for short term gains on stocks you do not propose to hold for longer term, or are you an investor, looking for returns both from capital growth and also income perhaps.
So let’s start by looking at some of the more popular stock trading strategies, and the pros and cons of each before looking in detail at one, which I believe is little understood but has the greatest potential if you are prepared to spend a little time learning and practicing.
Choosing the right strategy
If we begin with the simplest of all, which is trading in the cash market. As a general rule this is normally associated with a large trading account where stocks or shares are held for months or years, generally over a five year time horizon. Normally trading is executed in a margin account, but with a maximum leverage of 50%, the account needs to be significant to benefit from this investment approach.
For the speculator, there are several attractive strategies, which require much smaller margin accounts, and yield greater returns.
The first of these is to trade in the futures markets, which has several advantages over the more traditional cash equivalent. First, the stock future generally has a lower margin requirement, normally around 20% so it provides a very efficient way to trade in the equities market but with a lower capital requirement. Secondly, the single stock future gets around the problem of the uptick rule when going short. Finally, going short is very simple, unlike the cash equivalent where the stock is borrowed from the broker and then returned once the trade is closed. Many traders who short stocks fail to appreciate that whilst holding the position, they are also liable for any dividends to the real owner of the stock. A nasty surprise often awaits the unwary.
For those in the UK and other parts of the world we have a unique trading approach based on something called spread betting, which in essence is a two way spread quoted by the broker on the underlying cash market. The trader simply buys or sells the quoted two way spread accordingly, and these instruments are now widely available on a huge range of stocks in both the UK and the US markets in particular.
Indeed these markets have now developed into more exotic instruments such as fixed odds and binary options, and this leads me neatly onto options, which I believe are one of the least understood instruments in the financial markets, and yet for stock traders, offer a fantastic way to trade, with a low risk, and a small amount of trading capital. Why more traders don’t trade options is beyond me, so let me explain what they are and how to use them as part of your stock trading strategy.
Many people think of options as risky. They are not, in fact quite the reverse and used correctly they are a great way to speculate in stocks with a small amount of trading capital. So what is an option ? Put simply, it is just that, it is an ‘’option’’ to buy or sell something, and as the holder of an option on a stock you have the right, but not the obligation to exercise the contract at any time up to the expiry date of the option. So in simple terms, and unlike a futures contract where you have to fulfill the contract, as an option holder you have an option to either do something or to do nothing – the choice is yours. When you buy an option, the price you pay is called the premium which is the maximum you risk on the trade, no more and no less, and which of course would be less if you decide to close your position before expiry.
All options have a strike price, which is the price at which the option is struck and as the underlying cash market moves, then the option moves in and out of the money. So for example if we buy an option on General Electric at $20.00 with an expiry in one month’s time, as the underlying stock moves higher in the cash market, then the value of the option will increase accordingly, and is said to be ‘ in the money’. The option can be closed at any time for a profit or simply left to expire and then settled in cash in your account. If the market falls then the GE stock price will also fall, and the option is likely to move ‘’out of the money’’, and into a loss, but you can then simply sell the option back to the market to save any further loss developing.
In order to allow traders to trade both sides of the markets, there are two types of options available, namely call options and put options. The reason for this is simple. Call options increase in value as the underlying stock price increases, and put options increase in value as the underlying stock price falls. So if you think the stock price will rise, then you buy call options, and if you thinks the stock price will fall you buy put options. And that in simple terms is how options work. The only thing you must never do is sell an option without holding the underlying stock, which is often referred to as naked selling.
Before we look at some simple stock trading strategies using options, let me just summarize the key elements of an option as follows :
This is the amount you pay for the right to hold the option on the stock. It is your maximum risk on the position. If you buy a call option, and the underlying stock price moves higher then the premium on the option will increase in value, allowing you to close your position and sell it back to the market for a profit. Equally if you buy a put option, and the underlying stock price moves lower, then once again the premium will increase in value, and you can either hold to expiry or sell back to the market and close the option. An option premium has two elements which combine to create the value, namely intrinsic and extrinsic. Intrinsic refers to whether the option is in the money or out of the money, and extrinsic is the time value left in the option.
All options expire, and are generally referred to as wasting assets. The closer that the expiry approaches then the faster that time erodes, as there is less chance that the option will move higher or lower as expiry approaches. Most stock options are dated in one month intervals, although you can also buy stock options over much longer periods in the future such as 12 or even 18 months. The monthly stock options in the US normally expire on the third Friday of each month.
The most common type of option is the American style which can be closed out at any time up to the date of expiry. This is the most common for US stock options which is the largest and most liquid in the world
This is the stock and the underlying price in the cash market will dictate the option price accordingly.
This is the price of the option that you buy, so it is an option to execute your option contract at this price. Each stock will list many different strike prices and the further the cash price is from the strike price then the cheaper the option will be, since there is less chance of the cash price moving to the strike price in the time before expiry.
The contract multiplier is the number of shares or stocks which underwrite the option. For a US stock option this is 100, ( in the UK it’s 1000 ) so if you see a premium quoted on an option of $2.50, then the premium on the option will be $250.
So having covered the basics of an option, let’s now look at an example of a stock option and how it is presented, and these are called option chains, where all the information for an option is presented in one table. It’s looks complicated but in fact is very simple.
First, the option chain displays call options on the left and put options on the right, with the strike price in the middle, and the stock here is GT which is Goodyear Tyre, one of my favourite stocks for a strategy I will explain shortly. As we can see, the stock closed the previous session at $15.28, so call options with a strike price of $15.00 and below are all in the money, and those at $16 and above are out of the money. Equally for puts, the reverse is true, so those at $16 and above are in the money, and those below $15 are out of the money. The premium quoted is in the last column, so if we were to buy a call option at a strike price of $15, then this would cost us 0.55 x 100 or $55. Finally the open interest column tells us how many option contracts are open and as this is a very liquid stock with plenty of option holders, these are big numbers, which simply means you will be able to buy and sell your option, whenever this is required.
Stock option strategies
Buying calls and puts
To round off this section using stock options, let’s look at a couple of simple examples. The starting point is with the Market Analyzer in NinjaTrader, and here we are looking for those turning points in the trend which signal a reversal. Once signaled we drill down into the chart and wait for our indicators to line up.
As we can see in the daily chart for Goodyear tyres below, the picture is very bullish for the stock. So time to buy a call option but which one? We have two choices, either an in the money at the strike price of $15, or an out of the money at $16. The first will cost us 100 x 0.55 or $55 and the second would be 0.10 x 100 or $10 – sounds cheap doesn’t it!
Well, there’s a reason it’s cheap – remember that all options expire, and here we are looking at an option chain for January ( the next one is February and then April ), so this option is due to expire in under two weeks, and remember that the time element unwinds faster as we approach expiry. So the question is, do we think that the GT stock is likely to reach $16 or more in the time left, and unless there is a significant news release in the interim, the answer is probably not since the movement of GT on a daily basis is relatively small, as the stock is not volatile. So if we stay with this example my choice here would be to buy the January in the money option at a strike price of $16, and then hold until expiry. The alternative of course for a longer term trade would be to look at the February call options and choose one from there.
Here of course the $16 strike price is more expensive at 0.50 x 100 or $50 which is as we would expect, since the we are now looking at an option that has five or six weeks to expiry and therefore a much greater chance of achieving the strike price and moving into the money, so it is more expensive.
The rule here is simple – find your stocks using the Market Analyzer, and then choose your stock options wisely, and don’t be fooled into thinking that cheap is the best. Generally they are cheap for a reason, and the reason is simple – they have virtually no chance of achieving the strike price and you will therefore lose all or most of your premium. So buy your options wisely, and don’t be afraid of buying in the money. My preference is to always buy slightly out of the money if possible, but always bear in mind how long the option has to expiry when making this decision. If it has a few weeks, then this is the best strategy, and for a February option I would buy the call at $16. For the January call option I would buy the $15 as it is already in the money and showing strength and I can sell my option back to the market at a profit before expiry if I wish.
Covered call strategy
The second simple strategy, and again a low risk approach using stock options is the covered call. Here we are taking the other side of the option and becoming a seller, rather than a buyer. Selling an option without holding the underlying asset, the stock in the case, is very dangerous, which is why it is called a covered option, since we are covering our risk by holding the underlying stock. Now of course as the option seller, we receive the premium when we sell the option, so this is income to us, but in addition of course we have had to buy 100 GT stocks at the market price, so in this case we would have had to pay $1528 for the underlying stock, and in return receive a small premium. So let’s suppose we decide to sell the February call option at a strike price of $16, then we have two ways to profit here.
First, we have generated an income by selling the call option and for this we receive 0.50 x 100 or $50 which we of course keep. Second, we are now holding 100 shares in Goodyear Tyres, and if, as predicted the stock is bullish, then as the stock rises in value, then so does the covered element of the strategy. Suppose at expiry the stock price has risen to $16.50, then we have made a profit of $1600 ( the strike price ) – $1528 = $72 plus of course our premium of $50, for a total of $122. In selling our option at the strike price of $16, we have of course given up any future gains if the stock moves higher, but this is an excellent low risk strategy to use in markets which are only mildly bullish.
Another great way to trade stocks is to look for those in sideways congestion, and then to write covered calls against the stock. Using this strategy you can then sell repeated options every month as one expires out of the money for the call buyer, and you as the seller simply sell the next month for another premium. It’s rather like renting your stocks out, just like a property. My best so far is to repeat this on the same block of stock, six times in a row, before the option was finally exercised when they broke higher and out of the narrow trading range.