15 Building Blocks for
By John Jagerson and Wade Hansen – Editors, SlingShot Trader
Table of Contents
One of the keys to successful portfolio management is diversification. Depending on their goals, many investors divide their portfolio into stocks, bonds and trading – and if you really want to maximize your money, options trading is for you. With options you have the opportunity to take a small amount of money and double or triple it in a short period of time.
Here at SlingShot Trader, we have a very aggressive trading philosophy that we use to book huge profits for our subscribers. Imagine a baseball player stepping up to the plate. He can either play it safe over and over again and bunt the pitch for an easy single every time, or he can give the ball a big whack and knock it out of the park. Well, SlingShot Trader is like the Great Bambino of options trading services. We have an aggressive trading strategy that allows us to hit big home runs just by stepping up to the plate.
If you read enough trading books and options guides, you'll see that most say that you can or should only buy in-the-money options; and that may be fine – for the conservative investor who never wants to make it past first base. However, with the SlingShot Trader strategy, we focus on news-based events, such as earnings and economic announcements that are going on at any given time in the market, in order to give ourselves the most competitive advantage over our conservative trader counterparts.
A lot of the time, we are buying options with at-the-money or out-of-the-money strike prices, which are sometimes more volatile than those that are in-the-money. But that volatility is exactly what allows us to make huge profits off of our home run trades.
To help you achieve this goal, we have created “15 Building Blocks for EXTREME Profits.”
With this report, you have everything you need to quickly learn the basics of options. And if you are already familiar with options, it's a great refresher course. In no time you'll be ready to get into your SlingShot Trader options trades and begin making some great profits. So let's get started right now.
An option is exactly that – it's a choice (or option) that you have in how you play the stock market. It's a securities contract that gives you the right to buy (call) or sell (put) at a predetermined price (strike price) during a preset time period (expiration date).
You've already seen how options strategies work every day without realizing it. In fact, you probably already have purchased the right to protect yourself against risk in some area of your life, such as home, health or car insurance. Those same principles are applied to the options market.
Let's use car insurance as an example. You purchase a new car after taking time to decide which model you want and how well it will accommodate your needs. But you can't drive off the dealer's lot without taking precautions in the form of insurance in the event that something happens to your investment!
When you buy any kind of insurance policy, you pay a premium for the protection it provides. The policy ultimately might be valued at several times more than what you actually pay for it, but the nominal amount you're charged for this “security net” is a small price to pay in comparison.
When you purchase options, it's called an options contract. One options contract controls 100 shares of the underlying stock. For example, if Ford (F) is selling for $10 per share, it would cost you $1,000 to own 100 shares. But by purchasing the call option, you can control those 100 shares for a fraction of the cost – $0.69 x 100 = $69. (We'll go into how the cost of the options contract is determined a little later.)
Since each contract controls 100 shares of stock, so when you hear people talk about one contract, they're talking about 100 shares. Two contracts would be 200 shares, and five contracts would be 500 shares.
With any options strategy that you implement, you can make it as big or as small as you like. It's really up to you! It's also important to remember that when you purchase options, the price quoted will be per share and not per contract. You will need to do the simple calculation below to determine the actual price.
Number of Contracts x Price per Contract x 100 = Total Cost of Trade
(Also known as the premium)
Here are a few examples:
The amount you pay to enter into an options contract is called a premium. You're not paying for the full value of a stock. For instance, if you wanted to get in on Yahoo (YHOO), you'd be paying around $20 per share. Buy 1,000 shares outright, and you have to invest $20,000.
We're not saying you can't play the market that way, but it isn't the only way, and it might not be the BEST way. And it's certainly not the least expensive way. But there's a way to play Yahoo – and thousands of other stocks – with a much smaller initial investment AND with the potential return that can equal and oftentimes even SURPASS what the traditional stock investor will see.
Options are classified as “in the money,” “at the money” or “out of the money.” Each of these phrases has a distinct meaning, and each option strike price will fall into one of the three categories.
If you keep in mind that options convey rights to the buyer, then the differences between the three types will be easier to understand. Let's quickly review the rights.
Calls – A call gives you the right to buy the stock for the strike price anytime before expiration.
Puts – Buying a put gives you the right to sell the stock for the strike price anytime before expiration.
Take a look at the chart below for a quick review.
There are three things to remember that will help you keep these terms straight.
Now let's take a look to see how an option's price is determined.
The strike price is an important and static part of the options contract. For every stock offers options, there are different expiration dates and strike prices.
To reduce confusion, the exchanges determine strike prices based on the current stock price.
The option you choose to buy or sell is largely based on the strike price of the option. For instance, if you think that Yahoo (YHOO) at $20 has a shot of rallying up to $25 a share in the next few months, you might want to buy a $25 Call with an expiration date of two or more months in the future.
Why is that? Because if Yahoo stock goes up to $25 before expiration, then you're holding a very valuable opportunity in your trading account.
During the time that you're in that options contract, you have the right to buy Yahoo stock at $25 a share while others in the marketplace will have to buy it at the market value, which could be much more than you're paying. Thus, you've bought yourself the right to buy stock at an agreed-upon price during the life of your options contract.
But remember that you have the right, but NOT the obligation, to buy that stock. If the stock has increased in value, chances are on your side that the value of the option has gone up as well, and others will want the right to buy YHOO for $25 especially if the market rate is $30 a share. And you can make a profit by selling your right to buy the shares at that price to someone else. Talk about a win-win situation!
When options began trading in 1973, a limited number of securities traded on the market. But today with the growing number of optionable stocks, indexes and LEAPs available, it was becoming difficult to create unique symbols using the existing three- to five- character system that was in place.
So, on February 12, 2010, all options tickers became 21 characters long. Although this seems like it would make it much more difficult to understand, it actually created a uniform format that could be universally understood by everyone in the markets.
Going back to the Yahoo example – you think YHOO is going to go up to $25 in the next few months. You would look for a call option (because you think the price will go up) and then you would give yourself time for the price to go up. Most traders go out a few months. So, you might want to look at the May 25 Call – YHOO130518C00025000.
Now, on first glance, YHOO130518C00025000 looks pretty confusing. But let's take it apart:
Options Root – Year – Month – Expiration Date – Type of Options – Strike Price
Review this chart below for a few more examples:
With all this said regarding option symbols, a few brokers have chosen to use their own format; so make sure you are aware of what format they are using. What we have described above reflects the industry standard.
Much of the mystery behind options trading is that it seems difficult to make sense of all the components at first. But once you learn the lingo, then you can craft it into an art that works for you individually.
Although the price of an option is influenced by many factors, 90% of the price is based on these three factors.
As I mentioned earlier, the market price of the underlying security (be it the stock, index or exchange traded fund) is where you start once you've identified the underlying asset on which you want to trade options. The stock price greatly – and perhaps predominantly – affects the price of the options available.
Options are a wasting asset (i.e., they expire), so time erodes the value of all options. The further away the option is from expiration, the more value it likely could have. As the option approaches expiration, the time decay accelerates because there's less time for the option to move in your favor and result in profits. It's useful to factor this into your options trading decisions because you may want to buy options with more time (longer until expiration) than you think you may need. That gives you enough time to be right..
The chart below shows you how time erodes an option. If it's May and you purchase a September option, then you're giving yourself about five months for the option to move in your favor.
With this September option that's purchased in May, there will be very little time decay in May, June and July. But as you get closer to September, the time decay speeds up, with the steepest decline occurring in the last 30 days before the option expiration, which is always the third Friday of the month for trading purposes.
After the market price of the stock, volatility is the second-most important factor in the determination of an option's price. Options on stocks that have been stable for years will be more predictably priced and, accordingly, priced lower than options on stocks with charts that are all over the place.
History isn't the only determining factor. Implied volatility also affects an option's price because it's based on the amount of volatility the market maker believes the stock is likely to experience in the future. A stock on the move will go up in price as more and more people want to get in on the action.
As the stock starts to move, the options market maker usually adjusts the implied volatility upward, which means the options premium will rise, all else being equal. The options will be worth more to investors who want to lock in a certain price at which they'd be willing to buy the stock.
Let's take Apple as an example. Suppose it's trading at $450. Then the company introduces a product that's even hotter than its iPad or iPhones, and the shares take off into the $475 range with no signs of looking back. You'd better believe that folks will want to secure their right to buy shares at $450 or any other strike price below the current stock price.
Every option (whether it's a call or a put, expiring in a month or a year) always will have a “bid” and an “ask” price. Said simply, you buy at the ask price and sell on the bid.
For example, if you're looking at Nov 75 Calls and you see prices of $47.20 X $51.10, then you'd be buying at the ask price (the higher price) and selling at the bid price (the lower number).
The difference between the bid and ask prices is the “spread.” The narrower the spread, usually the better the liquidity (liquidity is the ability to move in and out of a position easily.)
Many investors get excited about options trading because they love the leverage they wield when the investment goes well. While stock investors might make 10%–20% returns on a stock, options investors could make a 100%, 200%, or sometimes even a 1,000% return in the same amount of time.
As an option trader, your risk is often a function of whether you are long or short, and how quickly you think you can get out of a bad trade.
For example, a long option has a fixed risk of the premium or purchase price. However, types of short option plays have theoretically unlimited risk since the market may move up or down infinitely.
That means that your maximum loss may be just the option premium in the case of a long option, or your stop loss in the case of a short option or long stock position. Once you know what your maximum risk is, you can determine your position's size.
You can determine the size of a position by dividing that maximum risk amount into the total amount of your portfolio you have set aside for a trade.
For example, if you assume that you are willing to use $10,000 of your portfolio for options trades and you are willing to risk 5% of that amount on any single trade, you are willing to lose $500 in a bad trade. Therefore, if you are evaluating a long call or put position with a max loss of $250 per contract, you could buy two contracts.
It's very important to stay consistent in your trading. One of the main reasons many traders aren't successful is simply because they are not consistent in their position sizing.
We recommend that you put 2% – 5% of your portfolio towards each trade. So, decide on the amount you're willing to risk in each position and stick to it.
For example, if you have a $15,000 account and you want to risk 3%, you would put $450 in each position. So, no matter what's going on in the market, you would put $450 towards each trade.
It's very easy to fall into the trap where you become a “see-saw investor.” This is where you have very large positions when you're confident and then you take only tiny investments when you're nervous.
The problem with this is that you can end up taking some huge losses that you can't recoup if the market turns against you.
By keeping a consistent amount invested and cutting your loses while they are still small, you are able to weather your bad trades and still watch your portfolio grow.
All options expire – most at zero value. Unlike stock investing, time is not your friend when you have long options. The closer an option gets to expiration, the faster the premium in the option deteriorates.
This deterioration is very rapid and accelerates in the final days before expiration. As an options investor, you should invest only a dollar amount that you're comfortable losing, because you could lose it all.
There are three things you can do to put time on your side:
Because options are highly leveraged investments, pricing moves very quickly. Options pricing, unlike stocks, can move by giant amounts in minutes or seconds rather than hours or days.
Small movements in a stock can translate into big movements in the underlying options. So how can an options investor make money unless he or she watches the options pricing in real-time all day long?
Answer: You should invest in opportunities where you believe the profit potential is so robust that pricing by the second will not be the key to making money. In other words, go after large profit opportunities so that there will be plenty of reward even if you aren't precise in your selling.
Additionally, do all you can to structure the options purchase using the right strike prices and expiration months so that much of this risk is reduced.
Buying a call option, or making a “long call” trade, is a simple and straightforward strategy for taking advantage of an upside move or trend. Once you purchase a call option (also called “establishing a long position” in the option), you can:
A call option gives you the right, but not the obligation, to buy the stock (or “call” it away from its owner) at the strike price at which you purchased the options for a set period of time (when your options will expire and no longer be valid).
Your main reason for buying a call option is because you believe the underlying stock will appreciate before expiration to more than the strike price and premium you paid for the option so that you'll be able to turn around and sell it at a higher price than what you paid.
The maximum amount you could lose with this trade is the initial cost of the trade (the premium you paid), but the upside is unlimited. However, because options are a wasting asset, time will work against you. So be sure to give yourself enough time to be right.
Let's take a look at one of our trades. This February, we recommended the March 39 Calls in Comcast (CMCSA 130316C00039000). We got into the trade at $0.75 and six trading days later sold to close the position at $2.90, making a quick 286% profit.
Ok, now let's recap. The trade was a call option trade in Comcast that would have expired March 16, 2013 for a much smaller gain if we hadn't sold it after a big jump in mid-February
In SlingShot Trader, we'll occasionally want to capture profits on the downside, and buying put options is a great way to do it. This allows you to capture profit from a down move the same way you capture money on calls from an up move. Many people also use this strategy to protect stocks they already own.
When you purchase a put option, it gives you the right (but not the obligation) to sell (or “put” it to someone else) a stock at the specified price for a set time period (when your options will expire and no longer be valid).
For many traders, buying puts on stocks that you believe are headed lower can carry less risk than shorting the stock and can provide greater liquidity and leverage. Many stocks that are expected to decline are heavily shorted. Because of this, it's difficult to borrow the shares (i.e., short them). On the other hand, buying a put is generally easier and doesn't require you to borrow anything. If the stock moves up, your loss is limited to the premium paid if you buy a put. If you're short the stock, your loss is potentially unlimited.
Although in SlingShot Trader we will not be selling puts, it is another strategy to be aware of. This is risky because you can get the stock “put” to you and be required to buy the shares. However at times, for experienced traders, selling puts can present a very good opportunity.
Let's take a look at a sample trade buying a put. The trade is the May 60 Puts in Deckers Outdoor Corp. (DECK 120519P00060000). We got into the trade for $1.25 and three days later closed the trade at $6.00for a 380% profit.
Below are the details of the trade broken down step-by-step. The trade was a put option trade in Deckers Outdoor Corp. that expired May 17, 2012. We expected the stock to be $60 or lower by the time it expired.
Once you've closed out your call or put trade, or let it expire, you should have a standardized way of calculating your profits or losses. At Slingshot Trader, we advocate a disciplined trading style and this is an objective way to track your performance.
Knowing how to calculate your profit or loss is an important way to help you manage your portfolio. The options market is very volatile and has big swings up and down. It's not unusual to be up 50% one day and down 30% the next.
That's why it's important to take your winners off the table and not let your entire trade ride in the hopes of trying to capture a huge home run. Most options traders try for a 30% to 100% profit before closing their trades.
The amount you have at risk and could potentially lose is the amount you put into a trade.
The mathematical formula to determine your profit or loss is:
Dollar amount after closing trade − Amount you have at risk ÷ original investment
Here are a few examples.
Example A. You bought one contract of call options in Kelloggs at $0.85 and closed it one week later for $1.50.
Dollar amount after closing the trade = $150 ($1.50 x 100*)
Amount you have at risk – 85 ($0.85 x 100*)
Divided by original investment 65/85 = 0.76 or 76%
*Each options contract controls 100 shares of stock.
Example B. Same Kelloggs trade as above, but now you buy 10 contracts.
$1,500 (150 per contract x 10 contracts)
– 850 (85 per contract x 10 contracts)
650/850 = 0.76 or 76%
The calculation is the same in reverse if you have a losing trade. The formula above does not include your trading cost since each broker's rates are different. If you want to add in the cost you incur when putting on and closing a trade, you would include that cost in your original investment.
Example C. Same Kelloggs trade as example A – with the addition of your broker charges, which is $7.00 for each part of the trade, so your total brokerage free for this trade is $14.00.
This makes your original investment for 1 contract of the Kelloggs 85 calls $99 ($85 + $14 = $99.)
Dollar amount after closing the trade = $150 ($1.50 x 100*)
Amount you have at risk –85 (0.85 x 100*)
Divided by original investment 65/99 = 0.65 or 65%
As you can see, it's not a difficult calculation. And we believe it's best to keep it simple and understand what your trades are really worth.
Now that we've gone over options trading, from the basics to the more advanced strategies and have joined SlingShot Trader, you're well on your way to profits.
Wade and I will continue to monitor the calendar of economic reports, corporate earnings from companies large and small, and the latest political headlines for opportunities on both the long and short side and send you out the best trades to lock in profits.
Be sure to keep this guide handy as a quick reference tool and make sure you watch you emails for our next Alert or Weekly Update. We're looking forward to helping you make money trading options.
John Jagerson & Wade Hansen
Editors, SlingShot Trader
InvestorPlace Media, LLC. All rights reserved.
700 Indian Springs Drive
Lancaster, PA 17601
For more information visit us at www.investorplace.com