Blueprint for Options Success
September 29, 2020
Simple Strategies for Big Gains
A lot of investors think buying options is a quick way to make big profits.
Sure, if you get really lucky, you might make money for a while. But really, buying options is one of the fastest ways to deplete the value of your trading account.
That’s because options are a “wasting” asset. More on that in a minute…
The truth is, if you really want to maximize your money — while taking little to no risk — selling options is for you.
By selling options, we can collect steady income on a regular basis. And if a trade turns against us, we can use it to our advantage by picking up shares of stock at a discount to their current value.
From there, we can sell more options to work that stock position back to profitability.
But let’s back up for a moment… To introduce you to options, we’ve created The Blueprint for Options Success: Simple Strategies for Big Gains.
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 options trades and begin making some great profits. So let’s get started right now.
What Are Options?
You’ve already seen how options strategies work every day without realizing it. In fact, you have probably already purchased the right to protect yourself against risk in some area of your life, such as home, health or car insurance.
Those same principles can be 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 an insurance policy — be it automobile, health, life or homeowner’s insurance — you pay a premium for the protection it provides.
This is the role that the option buyer plays in the markets.
But most of the time, you don’t end up needing that insurance, and the insurance company simply pockets the money you paid them.
This is the role of the option seller.
This is why we only sell options… It’s far more likely that we will get to keep the premium that is paid to us, which is why insurance companies are so profitable.
The option premium is simply the price to enter into an options contract. If you are buying an option, you will pay the premium. If you are selling an option, the buyer pays you the premium.
We’ll go into more details on the price of options later on, but right now let’s talk about the call and put option strategies.
Options-Trading Strategies: Selling Puts
With this strategy, we want to collect income on stocks that are making bullish moves. Selling put options is a great way to do it. Often times, we’ll sell puts on stocks we wouldn’t mind adding to our portfolio.
A put option gives the buyer of the option the right to sell 100 shares of stock to the seller of the option for the strike price for a certain amount of time before the option contract expires.
Selling puts can be incorrectly perceived as “risky” because the seller can get the stock “put” to them and be required to buy the shares. However, from our perspective, selling puts can present a very good opportunity.
There are two potential outcomes when selling a put:
- The stock falls below the strike price of the put. That means the put seller is obligated to buy the stock from the put buyer at the strike price.
- The stock does not fall below the strike price and the put loses value before expiring worthless. Most of the time, we will buy back a put write that is out of the money and has lost most of its value.
Let’s take a look at a sample trade selling a put.
Trade Example #1
The trade was the Microsoft (MSFT) September 21st $111 Put Write (MSFT180921P00111000). We earned $145 when we sold the put, and 20 days later bought it back for just $17.
That’s resulted in a 5.59% return on margin, or 169.94% annualized.
Below are the details of the trade broken down step-by-step. The trade was a put write in Microsoft with an expiration date of Sept. 21, 2019. We expected the stock stay above $111 through expiration.
- The option symbol was: MSFT180921P00111000
- To open the trade, you “sell to open.”
- To close the trade, you “buy to close.”
- This was a put write in Microsoft.
- This trade obligated you to buy 100 shares of Microsoft stock for each option contract you open for $111 per share even if the price goes below that.
- This option was a depreciating asset because it was set to expire in September and then become worthless.
- In just 20 days, we closed the trade, capturing a 5.59% return on margin. That’s an annualized return of 169.94%!
But what about trades that expire in-the-money? We mentioned above that we sometimes accept stock that is put to us.
Let’s look at another example. (Remember, we don’t mind owning shares of Microsoft, as it’s a very strong, blue-chip company with great prospects for long-term appreciation.)
Trade Example #2
The trade was the Microsoft (MSFT) December 21st $110 Put Write (MSFT181221P00110000). We earned $139 when we sold the put and, at expiration, the option was in the money. The buyer put the stock to us on Dec. 21, 2018, but we still got to keep the $139 in premium we received for selling the option.
Below are the details of the trade broken down step-by-step.
- The option symbol was: MSFT181221P00110000
- To open the trade, you “sell to open.”
- To close the trade, you “buy to close.”
- This was another put write in Microsoft.
- This trade obligated you to buy 100 shares of Microsoft stock for each option contract you open for $110 per share even if the price goes below that.
- This option was a depreciating asset because it was set to expire in December and then become worthless.
- We held this trade for 18 days. On expiration day, MSFT closed below the strike price at $98.23, meaning the option expired in the money. We accepted 100 shares of MSFT stock for each contract we sold, but we also got to keep the premium we earned when we opened the trade. So, we earned a return on margin of 6.40%. That’s an annualized return of 251.83%.
At the start of this section, we mentioned we typically sell puts on stocks we wouldn’t mind owning, but what do we do once we own those stocks? We don’t like to just wait for their value to recover, instead we use them to collect more income, which leads us to our next options strategy: Covered Calls.
Options-Trading Strategies: Selling Covered Calls
Just like a put write, a covered call involves selling an option to collect premium as income.
A call option is a contract that gives the buyer of the option the right, but not the obligation, to buy 100 shares of the underlying stock from the seller of the option at the agreed upon strike price any time before expiration.
Selling a call obligates you to sell 100 shares of a stock, which would be a bad idea if you don’t already own the stock. After all, you’d have to go out and buy 100 shares on the open market and then sell them back to the option buyer.
But if you already own shares of the underlying stock, you wouldn’t have to buy shares to sell to the call buyer. The shares you already own would “cover” the call you sold, hence the term “covered call.”
When we are put shares of a stock, we can sell covered calls on those stocks to generate more income.
Just like with a put write, there are two potential outcomes when selling a call option:
- The stock rises past the strike price and the call seller is obligated to sell 100 shares of the stock for the strike price.
- The stock does not rise past the strike price and the call expires worthless, allowing the seller to keep the entire premium. Just like with put writes, we might sometimes buy back a covered call that is out of the money and has lost most of its value.
Let’s take a look at a sample trade selling a covered call.
The trade was the Microsoft (MSFT) January 18th (2019) $100 Covered Call (MSFT190118C00100000). We earned $290 when we sold the covered call and, 18 trading days later, we bought the call back for just $262.
That resulted in a 0.25% return on invested capital, or 5.29% annualized. Not bad for 18 days in the position!
Below are the details of the trade broken down step-by-step. The trade was a covered call trade in Microsoft with an expiration date of Jan. 18, 2019. We expected the stock stay below $100 through expiration.
- The option symbol was: MSFT190118C00100000
- To open the trade, you “sell to open.”
- To close the trade, you “buy to close.”
- This was a covered call option in Microsoft, meaning we already owned 100 shares of the stock.
- This trade obligated you to sell 100 shares of Microsoft stock for each option contract you open for $100 per share even if the price goes above that.
- This option was a depreciating asset because it was set to expire in January and then become worthless.
- In just 18 days, we closed the trade for $262, capturing a 0.25% return on invested capital. That’s an annualized return of 5.29%!
But what happens when a covered call expires in the money? For that, we’ll look at another Microsoft example.
The trade was the Microsoft (MSFT) March 1st (2019) $110 Covered Call (MSFT190301C00110000). We earned $59 when we sold the covered call and, at expiration, the option was in the money. The buyer called away our Microsoft stock on March 1, 2019. Below are the details of the trade broken down step-by-step.
- The option symbol was: MSFT190301C00110000
- To open the trade, you “sell to open.”
- To close the trade, you “buy to close.”
- This was a covered call option in Microsoft.
- This trade obligated you to sell 100 shares of Microsoft stock for each option contract you open for $110 even if the price goes above that.
- This option was a depreciating asset because it was set to expire in March and then become worthless.
- We held this trade for 23 days. On expiration day, MSFT closed above our strike price at $112.53, so the option expired in the money. 100 shares of MSFT stock we called away from us at $110 per share for each contract we sold. If you recall, that was the same price we bought MSFT for in the put write example above. So, in this case, we broke even on the stock we sold.
- But, we got to keep the premium we earned when we opened the MSFT March 1st $110 Covered Call. So, we also earned a return on invested capital of 0.54%. That’s an annualized return of 8.86%!
With a covered call, we get to earn income on the stocks we receive when a put write expires in the money. That lets us collect steady gains regardless of how our trades turn out.
At the Money, In the Money, Out of the Money
Options are classified as either “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 the buyer the right to buy the stock for the strike price any time before expiration. The call seller is obligated to sell the stock for the strike price any time before expiration.
Puts — Buying a put gives the buyer the right to sell the stock for the strike price any time before expiration. The put seller is obligated to buy the stock for the strike price any time before expiration.
At the Money
Let’s assume that we’re evaluating a stock that is priced at roughly $100 per share for this explanation.
There is typically only one strike price that is considered “at the money.” That strike price is the one closest to the current stock price.
The at-the-money strike price is $100. That is because the current price of the stock is roughly $100 per share. There is no other strike price closer to current price of the stock.
In the Money
The in-the-money strike prices are those with “intrinsic value.” Intrinsic value means that the right conveyed by the option is worth something. For example, if you own the $90 strike call, you have the right to buy the stock for $90 per share. If the current price of the stock is $100, the option has intrinsic value of $10 per share.
Similarly, the $110 strike put has intrinsic value of $10 per share because that strike price is $10 above the current stock price.
Out of the Money
An option with a strike price that is out of the money is an option that has no intrinsic value. For example, if a put with a strike price of $90 gives you the right to sell the stock for $90 before expiration, that right has no value. That is because the stock is currently worth $100. Therefore, you could sell the stock on the open market for more than you have right to sell it through the option.
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.
- Puts with a strike price above the current stock price and calls with a strike price below the current stock price are “in the money.” The further the strike price is in the money, the more expensive that option will be because it has more intrinsic value. A short call or put that expires in the money will be exercised by the buyer. For calls, that means that the seller will have the stock called away from them. For puts, that means that the seller will have the stock put to them.
- Puts with a strike price below the current stock price and calls with a strike price above the current stock price are “out of the money.” The further the strike price is out of the money, the less valuable it becomes because it is less likely that the option will ever acquire intrinsic value. A short call or put that expires out of the money will not be exercised by the buyer. For both calls and puts, that means that the option will expire worthless and the seller keeps the entire premium they received for selling the option.
- At-the-money options may be a little in or out of the money. They will, however, always be the strike price that is closest to the current stock price.
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 that’s optionable (an equity that offers options), there are different expiration dates and strike prices.
To reduce confusion, the exchanges determine strike prices based on the current stock price. If a stock is trading between $5 and $25, then typically the strike prices will be in increments of $1.00, such as $5, $6, $7, $8, $9, $10 and so on.
If a stock is trading between $25 and $100, then typically the strike prices will be in increments of $2.50, such as $50, $52.50, $55, $57.50 and so on.
If the stock is trading above $100, then typically the strike price will be in increments of $5, such as $100, $105, $110, $115 and so on.
On occasion, you can find $10 intervals for stocks that are high-priced. These stocks usually are trading over $200.
Take a look at the three charts below to see how strike prices vary.
General Electric (GE) — $1.00 Strike Increments
Target Corporation (TGT) — $2.50 Strike Increments
NVIDIA (NVDA) — $5.00 Strike Increments
The option you choose to sell is largely based on the strike price of the option. For instance, if you think that Apple (AAPL) at $205 will stay above that level for the next month, you might want to sell a $205 put with an expiration date one month in the future.
Why is that? Because, if Apple’s stock stays above $205 or rises higher before expiration, the option will expire worthless, allowing the seller to keep the full premium they received when they sold the option.
During the time that you’re in that options contract, Apple’s value might rise, which would push the value of the option lower than the price you initially sold it for. If at any point you got worried Apple would fall below $205 or you just wanted to limit your risk, you could buy back your option for a lower price and pocket a profit.
However, remember that you are obligated to buy that stock if the buyer exercises the put option. If the stock has dropped below the $205 strike price, there is a good chance the price of the option will go up, making it more expensive to buy back.
But if you don’t mind buying 100 shares of Apple’s stock at $205 a share, you can let the put buyer exercise the option at or before expiration. You still get to keep the full premium you earned by selling the option, and as we’ll discuss later on, you now have the option to sell covered calls to earn more income.
This is why selling options is so lucrative…there are so many different ways to win. Unlike buying options, if a short option trade goes against us, we can still continue to collect income with little to no risk.
When options began trading in 1973, a limited number of securities traded on the market. But, as the number of optionable stocks, index funds and LEAPs available grew, it became difficult to create unique symbols using the existing three- to five- character system that was first put in place.
So, in 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 Apple example — you think AAPL is going stay above $205 per share for the next month. You would look to sell a put option (because you think the price stay the same or go up) and then you would give yourself time for the price to go up. For the sake of this example, let’s assume you are looking at June options. So, you might want to look at the AAPL June 21st $205 Put (AAPL190621P00205000).
Now, at first glance, AAPL190621P00205000 looks pretty confusing. But let’s take it apart:
Options Root — Year — Month — Expiration Date — Type of Options — Strike Price
- Options Root — AAPL — This is the options root that’s between one and six letters, indicating the ticker symbol of the underlying security.
- Year — 19 — These two characters tell you the year in which the option expires. In this case, it’s 2019.
- Month — 06 — The next two characters tell you the month that the option expires. Our Apple option expires in June, the sixth month of the year.
- Expiration Date — 21 — These two characters are the day the option expires. Monthly options technically expire the third Saturday of each month, but because the markets are closed on Saturdays, the options actually expire the day before, on Friday. So in this case, our option technically expires Friday, June 21, 2019.
- Type of Option — P — This letter tells you whether the option is a call or a put. “P” indicates a put option. A call option would be designated by a “C”.
- Strike Price — 00205000 — The strike price is composed of eight numbers. The first five are for the strike dollar, and the last three are for the strike decimal. In our trade, this indicates the option has a $205 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; what is important is just to know what format they are using. What we have described above reflects the industry standard for regular monthly options.
It’s also important to note that now there are also weekly and quarterly options; that is, options that expire each week and options that expire each quarter. Weekly and quarterly options are typically only offered on bigger-name stocks that are very liquid: Apple (AAPL), Google (GOOG), Amazon.com (AMZN), Microsoft (MSFT) and the like. Let’s look at how the exchanges denote different tickers for weekly and monthly options.
3 Factors That Affect the Option Price
Much of the mystery behind options trading is that it seems difficult to make sense of all the components at first. But once you realize that it’s a science and you master it accordingly, 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:
1. Stock Price
As 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 become in-the-money and become profitable for the buyer.
For us, the options sellers, time decay works to our advantage, reducing the cost of an option and giving us the chance to buy it back for a lower price and pocket the difference. That lets us lock in profits.
It’s useful to factor this into your options trading decisions because you need to balance the risk of selling an option with a longer expiration with the reward of more premium from the initial sale of the option.
The chart below shows you how time erodes an option. If it’s July and you sell a December option, then you’re giving yourself about five months for the option to move in your favor. If you sell an option that has a later expiration date, you are allowing more time for the stock to move against you.
With this December option that’s sold in July, there will be very little time decay in July, August and September. But as you get closer to December, the time decay speeds up, with the steepest decline occurring in the last 30 days before the option expiration.
It’s for that reason that the majority of the short options we recommend will have about a month left before expiration. Again, it’s during those last 30 days that the option loses the most value and provides the best risk/reward picture for us as option sellers. Remember, as option sellers, we are looking for the price of the options we sell to go down.
After the market price of the stock and the time until expiration, volatility is the next-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 whose charts are all over the place — up and down like a carousel horse gone amok.
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 again. Suppose it’s trading at $200. Then the company introduces a product that’s even hotter than its iPad or iPhones, and the shares take off into the $210 range with no signs of looking back. You’d better believe that folks will want to secure their right to buy shares at $205 or any other strike price below the current stock price.
For us, we want to sell options when volatility is high and the premium is elevated. After all, the higher the option premium, the more money we can collect per option sold. When volatility is low and the value of the option has decreased, that’s when we will look to potentially buy the option back for a lower price and pocket the difference.
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, at the time of this writing, the Apple (AAPL) June 21st expiration $205 strike puts have a bid/ask spread of $15.30/$15.50.
If we were to sell to open this option, we would be doing so at the bid price (the lower number). That’s the price that traders are willing to pay us for the option.
For the option buyer, they would have to pay the ask price (the higher number). That’s the price that the option seller is demanding to sell the option.
The difference between the bid and ask prices is the “spread.” As the spread narrows, the amount of liquidity is usually higher (liquidity is the ability to move in and out of a position easily).
Your broker will have all the quotes you’ll need to trade listed online. If you’re an active trader, you’ll have all the free, real-time quotes you need through that online service.
The Chicago Board Options Exchange (CBOE) is another source for option quotes. At CBOE.com, you’ll find a free 20-minute delayed screen. For different fee levels, you can get real-time quotes and even real-time streaming quotes.
Delayed option quotes also are available a Yahoo Finance.
Many investors get excited about selling options because earning consistent income with their trades. While stock investors might make 10%-20% returns on a stock after several months of waiting, options sellers get paid upfront for their trades and, often times, the options they write expire worthless.
Traders that sell short puts and covered calls are taking on specific risks. In the case of a put write, you risk being put stock, which we mentioned above. Let’s look at the Microsoft (MSFT) December 21st $110 Put Write, which expired in-the-money, again.
If we sold one contract, we would be required to purchase 100 shares for $110 per share at expiration. That would cost $11,000. Every put write carries the risk of exercise, however unlikely, which means selling too many options that expire in the money can be costly.
That risk also means your broker will require you to provide “margin,” which is a cash deposit in your account to cover the potential losses.
The margin requirement is determined by a simple formula. First take 20% of the underlying stock price, then subtract the amount the put is out of the money, and add the option premium. However different brokers may have different requirements.
In the case of a covered call, the risk is the buyer will call our stock away from us. Lets look at the Microsoft (MSFT) January 18th (2019) $100 Covered Call, which we sold after accepting the stock from the Microsoft (MSFT) December 21st $110 Put Write.
Assuming we had bought 100 shares of Microsoft for $110 per share, our invested capital is $11,000. If our covered call had expired in-the-money, we would have been required to sell our 100 shares for $100. The buyer would have paid us $10,000, and we would have lost money on our trade.
When selling covered calls, you sometimes risk losing money from your stock position.
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. This means investing approximately the same percentage of your portfolio to each position.
As a rule of thumb, the benefits of diversification start to fade once an investor takes on between 10-15 positions. Therefore, we recommend that you put 8%-10% of your total available trading capital in any given trade. Investors who are more risk tolerant may wish to use more capital and some traders may want to use less, but what’s important is to be consistent from one trade to the next.
Determining the amount to risk per trade would be easy if you are just buying stocks. For example, if you have a $15,000 account and you want to risk 10% on each trade, you would put $1,500 in a single stock investment. However, the calculation is a little trickier when using options.
When we sell put options, there is a small possibility that the put will be exercised and we will buy the stock. Therefore, although the risk of exercise is usually low, it makes sense to use the value of the stock to calculate your position sizing. Let’s run through an example with a put option with a $100 strike price.
You want to write or “sell to open” the put option to collect option income. The puts have a strike price of $100. If the you are put the stock, you will pay $100 per share. Since each put contract controls 100 shares, the theoretical investment after exercise is $10,000 per contract.
We recommend assuming some leverage for the position sizing calculation because exercise is not very common. In most cases, we suggest that investors assume a 4-to-1 ratio. With leverage, you can enter trades that are larger than your account funds can cover. In other words, if the theoretical investment after exercise is $10,000, then an investor would keep $2,500 — per put contract that is sold — in cash available in their account as the “investment” in the trade.
Your broker will require a minimum deposit to be reserved for each put that is sold. That required amount is less than what we have suggested here, but we feel that our more conservative approach helps traders remain consistent even in choppy market conditions.
Assume that you had $50,000 available for a put selling strategy and you are willing to risk 10% in any single position or $5,000. The previous calculation required an “investment” of $2,500 per put contract sold, so your position size would be 2 put contracts.
Using the steps outlined above, you can run some practice calculations to get the hang of consistent position sizing. For example, assume you planned to sell puts on a stock, and the puts have a $48 strike price. If you had $60,000 available for your put selling strategy and were willing to risk 8% per trade, how many contracts would you sell to open? [Hint: The correct answer is 4-contracts].
Position sizing is important because it’s very easy to fall into the trap where you become a “Seesaw investor.” This is where you have very large positions when you’re confident and on a winning streak 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 come back from because the market turns against you when you have the largest positions and have become overconfident. You also miss some of the best opportunities when the market is choppy and it’s natural to be a little more nervous.
Time is on Your Side
All options expire — most at zero value. When selling options, we can use this to our advantage to generate extra income over and over again with little to no risk. 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:
- Sell options at the money (or near the money). At the money options typically carry high premiums, which results in the option seller pocketing more money.
- Sell options with expiration dates that comfortably encompass the investment opportunity.
- Sell options when volatility is high for greater premium, and buy them back to close the position when volatility is low and the premium has evaporated.
How to Determine Your Profit or Loss in a Trade
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 for the price of an option to be up 50% or more one day and down 30% or more 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.
In our example trades, you’ll notice we described our profits for put writes as “return on margin” and our covered calls as “return on invested capital.”
Return on margin for a put write is calculated using this formula:
((Open Price – Close Price) * 100) / Margin
We think it’s useful to calculate profits based on margin because it gives us a better sense of how much income we are receiving versus how much money we have allocated for a particular trade.
In the case of the Microsoft (MSFT) September 21st $111 Put Write, we were required to put up $2,289.00 in margin. We received $145 when we sold the contract, and we bought it back for $17.
Calculating our profit would look like this:
(($1.45 – $0.17) * 100) / $2289.00
The end percentage is 5.59%.
For a covered call, we use “invested capital” to calculate our profits, which refers to the total amount invested in the stock we sell covered calls against. If you buy 100 shares of Microsoft at $110, your invested capital is $11,000.
As we mentioned earlier, the risk in a covered call position is that the call buyer will call away our shares of a stock. Therefore, in the same way that margin is at risk in a put write, the invested capital is at risk in a covered call trade. To calculate your return on invested capital for a covered call trade, we use the following formula:
((Open Price – Close Price ) * 100) / Invested Capital
In the case of the Microsoft (MSFT) January 18th (2019) $100 Covered Call, we previously purchased 100 shares of Microsoft at $110, making our invested capital $11,000. We received $290 when we sold the contract, and we bought it back for $262.
Calculating our profit would look like this:
(($2.90 – $2.62) * 100) / $11,000
As you can see, calculating your profits in a trade isn’t too difficult. And we believe it’s important to understand the value of your trades relative to the amount of money you’re risking because it helps you better understand your risk/reward picture.
Choosing a Broker
Now that you have all of the ins and outs of options trading, one of the most important tools you have is your broker. Even though most of the leading online brokerage firms are well-versed in trading options, all brokers are not created equally. There are also a number of options-specific brokerages that have tools to assist options traders.
Keep in mind, though, that, in general, the lower the commission, the less support you can expect. Full-service brokers can charge $2-$5 per options contract, while discounters might charge a low flat commission per trade, regardless of the number of contracts traded.
Applying is easy — and it often can be all done online. Expect to pay anywhere from $5.00 to $19.95 commission per transaction for an option trade. Some option brokerage firms have a $1.50 per contract commission schedule, with a minimum of, say, $14.95 per trade. (Meaning, even if you only do one contract, they will get you for the $14.95.)
Each broker has different rates and requirements (and may assign a different number to each level), but in general there are four different levels of option trading you can be approved for. Most brokers will approve you for level 0 or 1 when starting out. Make sure you’re approved for level 1 or higher so you can buy calls and puts.
Level 0 — This is the first level of approval and where you would need to have the most stocks or money to cover your positions. At this level, you would be able to sell calls and puts on the underlying stocks you own in your account.
You would also be able to sell covered calls. The covered call is one of the most conservative and least risky option strategies available. Before you sell the calls, you have to own the stock (i.e., you’re “covered”) in the event the stock gets called away from you. It’s simple, and there’s virtually no risk to the brokerage firm.
Buying calls and puts like we do involves having cash in your account (which is how all options settle). You buy a call or a put, and you are limited to losing the amount of your investment and nothing more. Again, the brokerage firm is not assuming too much risk here because you have the money/stocks in your account, and they place a freeze on them to make sure they are covered in case the trade does not go your way.
Depending on your account size, the brokerage firm and your past experience, you might not be approved (initially) for the higher levels.
Level 1 — Here you would also be able to buy puts and calls without owning the underlying securities. You could also do straddles that involve buying equal numbers of calls or puts on the same stock and at the same strike price. You would do this if you thought the stock were going to make a big move, but were not sure which direction it would be.
Another strategy you would be able to do is the strangle trade. This involves the same number of calls and puts on the same underlying security at different strike prices but with the same expiration date. Here you are hoping that the stock makes a big move, but you’re not sure at what price.
Level 2 — At level two, not only are you approved to do everything in the other two levels, but you can now begin to do credit and debit spread trades if you so desire.
At this level, you will also be required to have less up-front cash or securities tied up for the trades.
Level 3 — This is the highest level at which you can be approved by your broker. This level allows you to sell “naked puts” or “naked calls” and do more complex strategies. Because selling put writes is such a major part of this strategy, you’ll want to be at least level three to participate in our trades.
There is also a higher margin requirement for something like selling naked puts. Since you’re taking on an obligation to buy stock, the brokerage firm wants to cover their behind if you’re out there selling 50 put contracts to buy a $50 stock… that’s a $250,000 obligation if you are suddenly forced to buy 5,000 shares of stock at $50 each!
Each broker is different, but they will require you to have a certain amount in cash or stocks held in your account so they can see that you’ll make good in the event you have to fulfill your obligation.
As a general rule, you must have at least 25% of equity in your account, and the broker will front you 75% on margin. If you sell a put (giving somebody else the right to buy shares from you), the broker may freeze the total amount of equity in your account to cover this trade because they want to protect themselves if you have to cover the trade and buy the stock.
Again, rates vary among brokers, so make sure you talk to them.
Print out this guide and keep it handy. Below you will find a glossary of options terms and also a few worksheets with some quizzes that will really help you lock in the information you just read. This is a great reference that you will refer to again and again.
With this basic understanding of options, you can see how it can help you profit in any type of market. With a little practice you’ll be trading options like a pro in no time. We’re looking forward to helping you make money trading options.
John Jagerson and Wade Hansen
Editors, Strategic Trader
Glossary of Options Terms
Ask — The price at which a seller is offering to sell an option or stock.
At the Money — an option is at the money if the strike price of the option equals the market price of the underlying security.
Bear-Put Spread — When you sell a lower-strike put and then buy a higher-strike put. This trade has limited profit, but also you limit your risk. A fall in the underlying stock price increases the value of the spread.
Bid — The price at which a market maker is willing to buy a security (buy it from you). Whenever a quote is obtained, the bid is always the smaller number (on the left-hand side).
Bull-Call Spread — When you buy a lower strike call and simultaneously sell a higher strike call. This trade has limited profit, but also you limit your risk. A rise in the underlying stock price increases the value of the spread.
Buy Write (also see Covered Call) — Having a long position in an asset (stock), combined with a short position in a call option on the same underlying asset. The covered call option strategy is one of the most widely used by investors.
Call Option — In the financial world, a call option gives the option buyer the right, but not the obligation, to buy something (or to “call” it away from the owner) at a specified price over a specified period of time.
Chicago Board Options Exchange (CBOE) — The Chicago Board Options Exchange; the first national exchange to trade listed stock options.
Combination Trades — When you take a position in both the call and put options at the same time for the same underlying security.
Covered Call (also see Buy Write) — Having a long position in an asset (stock), combined with a short position in a call option on the same underlying asset. The covered call option strategy is one of the most widely used by investors.
Credit Spread — When you purchase one options and sell one option in the same underlying stock and expiration date but different strike prices at the same time. The option you sell provides you with a credit for entering the position.
Exercise — When you “exercise” a call options, you “trade in” your options for the actual stock (at the agreed-upon strike price). When you exercise a put option, you force the sale of stock you own at the predetermined strike price.
Expiration Date — The day on which an option contract becomes void. The expiration date for listed stock options is the Saturday after the third Friday of the expiration month, so for most trading purposes it is the third Friday of each month.
Exercise Price — Sometimes called the “strike price” is the price at which the option holder has the right either to purchase or to sell the underlying stock.
Implied Volatility — is the volatility that is expected to happen in the future to an option. It is a mathematical formula based on an option pricing model.
In the Money — For a call option, when the option’s strike price is below the market price of the underlying stock. For a put option, when the strike price is above the market price of the underlying stock.
Leverage — In investments, the attainment of greater percentage profit and risk potential. A call holder has leverage with respect to a stock holder ñ the former will have greater percentage profits and losses than the latter for the same movement in the underlying stock.
Long (or Long Position) — The buying of a security such as a stock or option with the expectation that the asset will rise in value.
Margin — Borrowed money that is used to purchase securities. This practice is referred to as “buying on margin.”
Margin Call — A broker’s demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. This is sometimes called a “fed call.”
Market Maker — A company or person who is ready to buy or sell securities at all times.
Option — A security sold by one party to another that offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time on or before a specific date.
Open Interest — Is the number of outstanding option contracts in the exchange market.
Option Chain — A way of quoting option prices through a list of all the options (calls and puts) for a given security.
Options Class — This is the underlying security the option is written on. In OMC Oct 45 Calls, Omnicom Group is the option class, or in MSFT July 30 Calls, the option class would be Microsoft.
Options Clearing Corporation (OCC) — The issuer of all listed option contracts that are trading on the national option exchanges.
Options Contract — Denotes the deliverable quantity of goods; options are traded in contract units. Each option contract represents 100 shares of the underlying stock. Hence, it’s necessary to multiply any option premium quote by 100 to get the true cost to the option buyer (or seller).
An option quoted for $2.50 really costs $250 for each contract.
Option Holder — The person who buys the right conveyed by the option.
Options Series — Is the expiration month and strike price of an option. In OMC Oct 45 Calls, the options series would be October and 45, or in MSFT July 30 Calls, the options series would be July and 30.
Option Writer — The person who is the seller.
Out of the Money — For a call, when an option’s strike price is higher than the market price of the underlying stock. For a put, when the strike price is below the market price of the underlying stock.
Premium — The total cost of an option. The premium of an option is basically the sum of the option’s intrinsic and extrinsic (time) value. It’s the price that the holder of an option pays and the writer of an option receives.
Put Option — A put option, in the financial world, gives the option buyer the right, but not the obligation, to SELL a stock (or “put” it to someone else) at a specified price, over a specified period of time.
Strike Price — The stated price per share for which an underlying stock may be purchased (for a call) or sold for a (put) by the option holder upon exercise of the option contract.
Style of Option — The style of an option refers to when that option is exercisable. American-style options can be exercised at any time prior to its expiration while European-style options are exercised only at expiration. All equity options traded in the U.S. are American style.
Time (Extrinsic Value) — The difference between an option’s price and the intrinsic value. Also known as “time” value. Extrinsic value is made up of several important variables: the number of days left until expiration, volatility, prevailing interest rates and dividends.
Time Decay — The amount of change in the option price, which will decrease over time as the option gets closer to expiration. Since options are a wasting asset, they lose value over time. This loss increases the closer it gets to expiration.
Trailing Stop — A stop-loss order that is set at a percentage level below (for a long position) the market price. The price is adjusted as the price fluctuates (it is not adjusted downward).
Unit of Trading — For most options on equity securities it is 100 shares.
Volatility — A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns.
Volume — The number of shares or contract that is traded in any given period of time within a security or an entire market.
Wasting Asset — An asset that declines in value over time. An option is an example because it is only valuable until expiration; after that, it becomes worthless.