The Self-Made Millionaire's Playbook for 2014 By John Jagerson and Wade Hansen Editors, Slingshot Trader
The Self-Made Millionaire's Playbook for 2014 By John Jagerson and Wade Hansen Editors, Slingshot Trader

One of the keys to successful portfolio management is diversification. Depending on their goals, many investors divide their portfolio into stocks, bonds, 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 all while limiting your risk.

To help you achieve this goal we have created: SlingShot Trader’s 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 your SlingShot Trader‘s options trades and begin making some great profits. So let’s get started right now.

Options Basics:
What Are Options?

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 an insurance policy — be it automobile, health, life or homeowner’s insurance — 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.

At the end of the year, when your car insurance needs to be renewed and you haven’t been involved in any accidents that required you to use your insurance, you still come out a winner because you didn’t lose any more than your initial investment (your premium), and you drove for a whole year with peace of mind because you had the insurance in the first place.

That’s the same principle used for options trading. For example, let’s say you think that Progressive (PGR), which is trading at $25 a share will go up to $30 within the next few months, but you don’t want to tie up thousands of dollars of your hard-earned cash. Well, by purchasing one options contract (which controls 100 shares) at $0.35 per contract, only $35 would be tied up, as opposed to the $2,000 required if you bought 100 shares of the stock outright.

The Cornerstones of Options Trading

There are two basic types of options: calls and puts.

Call options are securities that give the buyer the right, but not the obligation, to buy something (i.e., to “call” it away from its owner) at a specified price during a specified period of time. Typically, you buy calls when you’re bullish about the direction of the market and/or about a particular stock’s prospects.

Put options give you the right, but not the obligation, to sell stock (or “put” it to someone else) at a specified price during a specified period of time. Put buyers more often are bearish on the markets and/or a stock’s potential, so they purchase puts to profit from a downside move.

Put buying is similar in theory to shorting stock in that you expect the shares to fall below a certain price. However, the put buyer actually incurs less risk than the short seller, because the most you can lose when you’re buying options is the premium that you paid to get into the trade. The people who short stocks must come up with a lot of dough to cover their shorts if the stock price rallies higher.

For all options, there are always two parties involved — someone buying and someone selling. There are benefits to using each strategy. It’s all about knowing which choice is right for you at which time. And that’s why we’re here — to help you understand the terminology and strategies so you can make informed and CONFIDENT decisions when you’re ready to trade with SlingShot Trader!

The chart below is a quick review of what calls and puts allow you to do.

Call Put
Buy
(Owner)
Right to Buy
The Underlying Security
Right to Sell
The Underlying Security
Seller
(Writer)
Obligation to Sell
The Underlying Security
Obligation to Buy
The Underlying Security

Options Contracts

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 $16 per share, it would cost you $1,600 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 is determined a little later.)

Each options 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.

Number of Shares Number of Options
Contracts You Need
100 1
200 2
300 3
500 5
700 7
1,000 10
25,000 250

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
(Also known as the premium)
x 100 = Total Cost of Trade

Here are a few examples:

Premium

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 $40 per share. Buy 1,000 shares, and you have to invest $40,000.

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.

At the Money, In the Money, Out of the Money

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 any time before expiration.

Puts — Buying a put gives you the right to sell the stock for the strike price any time before expiration.

At the Money

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.

In the example below the at-the-money strike price for Yahoo is $40.00. That is because the current price of the stock is $40.00 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 owned the 30 strike call, you have the right to buy the stock for $30 a share. If the current price of the stock is $40.00, the option has intrinsic value of $10.00 per share.

Similarly the 45 put strike price has intrinsic value of $5.00 per share because that strike price is $5.00 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 30 gives you the right to sell Yahoo for $30 before expiration, that right has no value. That is because the stock is currently worth $40.00, 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.

Yahoo Calls With Stock Price at $40
Strike Price Status
$35.00 In the money
$37.00 In the money
$40.00 At the money
$42.50 Out of the money
$45.00 Out of the money
Yahoo Puts With Stock Price at $40.00
Strike Price Status
$35.00 Out of the money
$37.00 Out of the money
$40.00 At the money
$42.50 In the money
$45.00 In the money

There are three things to remember that will help you keep these terms straight.

  1. 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.
  2. 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.
  3. 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.

Strike Price

The strike price is an important and static part of the options contract. For every stock that’s optionable (one that offers options on the stock), 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 the strike prices will be in increments of $2.50, such as $5, $7.50, $10, $12.50, $15, $17.50 and so on.

If a stock is trading between $25 and $200, then the strike prices will be in increments of $5, such as $25, $30, $35, $40 and so on.

If the stock is trading above $200, then the strike price will be in increments of $10, such as $200, $210, $220, $230 and so on.

On occasion, you can find $1 intervals for stocks that are low priced but have heavy interest in them. These stocks usually are trading under $50.

Take a look at the three charts below to see how strike prices vary.

Alcoa (AA)

iRobot (IRBT)

Netflix (NFLX)

The option you choose to buy or sell is largely based on the strike price of the option. For instance, if you think that Apple (AAPL) at $550 has a shot of rallying up to $600 a share in the next few months, you might want to buy a $600 Call with an expiration date of two or more months in the future.

Why is that? Because, if Apple’s stock goes up to $600 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 Apple stock at $600 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 AAPL for $600 especially if the market rate is $650 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!

Options Symbols

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, 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 Apple is going to go up to 600 in the next few months. You would look for a call options (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 AAPL May 600 Call – AAPL140517C00600000.

Now, on first glance, AAPL140517C00600000 looks pretty confusing. But let’s take it apart:

  1. Options Root – AAPL – This is the options root that’s between one and six letters, indicating the underlying security (in this case, it’s the Apple stock).
  2. Year – 14 – These two characters tell you the year in which the option expires. In this case, it’s 2014.
  3. Month – 5 – The next two characters tell you the month that the option expires. Our Apple option expires in May, the fifth month.
  4. Expiration Date – 17 – These two characters are the day the option expires. Options technically expire the third Saturday of each month, but because the markets are closed on Saturdays, the options actually expire on day before, on Friday. So in this case, our option technically expires Saturday, May 17, 2014.
  5. Type of Options – C – This letter tells you whether the option is a call or a put. “C” indicates a call option. A put option would have a “P” here.
  6. Strike Price – 00600000 – The strike price is composed of one to nine numbers. The first five are for the strike dollar, and the last four are for the strike decimal. In our trade, this indicates it has a $600 strike price.

Review this chart below for a few more examples:

Options Root Year Month Expiration Date Type of Options Strike Price
GRPN140719C00010000
Groupon
2014 July 19 Call 10
SBUX141018C00082500
Starbucks Corporation
2014 October 18 Call 82.50
AAPL150117C00550000
Apple, Inc.
2015 January 17 Call 550
AAPL150117P00550000
Apple, Inc.
2015 January 17 Put 550
NKE160115P00070000
Nike Inc.
2016 January 17 Put 70.00

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, Google, Amazon, General Electric and the like. Let’s look at how the exchanges denote different tickers for weekly and monthly options.

Options Root Year Month Expiration Date Type of Options Strike Price
AMZN140314C00375000
Amazon Weekly Option
2014 March 14 Call 375
AMZN140321C00375000
Amazon Monthly Option
2014 March 21 Call 375
AMZN140328C00375000
Amazon Quarterly Option
2014 March 28 Call 375

This becomes important because if we are recommending a regular monthly option, you’ll want to make sure you’re selecting the correct one if weekly and quarterly options are also available. In addition, we do sometimes like the opportunity in a weekly or quarterly option more than the regular option, so you may see recommendations featuring non-standard options. Nearly every broker offers monthly, weekly and quarterly options, so don’t worry about that.

3 Factors That Affect the Options 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, 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:

1. Stock Price

As we 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.

2. Time

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 to give them a chance to make a positive change.

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.

3. Volatility

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 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 $535. Then the company introduces a product that’s even hotter than its iPad or iPods, and the shares take off into the $600 range with no signs of looking back. You’d better believe that folks will want to secure their right to buy shares at $535 or any other strike price below the current stock price.

Bid/Ask Prices

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.)

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.

Option quotes also are available at OptionsClearing.com.

Expiration Cycles

When you’re looking at securities that have options traded on them, you’ll notice the expiration dates and how they change from stock to stock. When a security begins to trade options, it’s randomly assigned one of three expiration cycles. That’s because there are so many stocks and securities trading options that it would be very difficult for the option market makers to keep track of every single call and put, at each strike price, for each month of the year.

So they created three common cycles to which the stocks are assigned:

The easiest thing to remember is this rule: There always will be current-month options (the “front month”), and there always will be options for the very next month. The only exceptions would be if a security is delisted.

For example, if it’s early September and you want to trade a Southwest Airlines (LUV) option, you’d find September options available (current or front-month) and also options for October.

One easy way to find out whether an option is available is to look at the options chain, which is available through your broker or on the finance pages at Yahoo! and Google. The options chain provides a list of all the months and prices which are available for a given security. At the top of the chart below, you’ll see that, in the month of April, there are options for April, May, June, July, September, December, January 2015, and January 2016.

Expiration Dates

What we love about trading options is that it’s all about making the most of volatility in a relatively short period of time. That means you can hold the options only from the trade open date until their expiration date.

Technically, options on stocks expire on the third Saturday of every month. But because the markets aren’t open then, options actually stop trading the third Friday of each month. So if you own a July option, you have from between the day you purchased the option until the third Friday of July for it to become profitable. On a few occasions, the underlying stock trades aftermarket on Friday of expiration week, which causes some action in your option.

During the time you own the options contract, you can exercise your right to sell the option, you can choose to buy the underlying stock at the agreed-upon price (e.g., if you purchased a Wells Fargo June 50 Call, then you can buy stock for $50 a share, even if the stock is trading at $60, as long as you do it before the third Friday in June, when the options contract expires), or you can choose to do nothing and the option will expire worthless without penalty to you.

Below you’ll find charts with the expiration dates for both 2014 and 2015. Remember, because the market is closed on the Saturday that the options expire, they actually stop trading the Friday before.

2014 Options Expiration Dates
Month Expiration
Date
Date Options
Stop Trading
January 18 17
February 22 21
March 22 21
April 19 18
May 17 16
June 21 20
July 19 18
August 16 15
September 20 19
October 18 17
November 22 21
December 20 19
2015 Options Expiration Dates
Month Expiration
Date
Date Options
Stop Trading
January 17 16
February 21 20
March 21 20
April 18 17
May 16 15
June 20 19
July 18 17
August 22 21
September 19 18
October 17 16
November 21 20
December 19 18


Understanding Risk

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 1,000% return in the same amount of time.

As an option trader what you really have at risk in a specific trade 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.

Position Sizing

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% on each trade, 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 “Seesaw 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 come back from because 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.

Time Isn’t Necessarily on Your Side

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:

  1. Buy options at the money (or near the money).
  2. Trade options with expiration dates that comfortably encompass the investment opportunity.
  3. Buy options where you believe volatility is underpriced, and sell options where you believe volatility is overpriced.

Prices Can Move Very Quickly

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.

Losses Can Be Substantial
on Naked Short Positions

Much like shorting stocks, shorting options naked (i.e., selling options without hedging the position with other options or stock) could lead to substantial and even unlimited losses.

Naked shorts in options means you’re selling a put or a call by itself. You might be wondering how else you could sell a put or a call. Well, the answer is that you could sell a put or a call in combination with stock or with other options that remove the risk of the naked put or call you sold. We’ll discuss this later when we briefly go over the Covered Call.

Although we use the word “short” to describe selling options to open, it’s not exactly the same structure as shorting a stock. When you short a stock, you’re selling borrowed stock. At some point in the future, you have to return the stock to its owner. With options, you don’t borrow any security. You simply take on the obligations that are associated with selling options for the premium payment.

What makes shorting options naked (which is also known as selling volatility) tantalizing is the possibility of having infinite gains. Much of the professional investment world has achieved gains from selling options, as the underlying stocks have been less volatile than what the options premium would imply.

For example, if we sold the Delta Airlines (DAL) Feb 35 Puts and collected $0.20, we would keep the $0.40 if the stock remained above $35 per share through February expiration. Much of the time, stocks don’t move as much as investors would expect.

There’s an important difference between selling to open a call naked versus a naked put. When you sell a naked call, your theoretical risk is infinite. You’re on the hook for the difference between the strike price and the amount the stock moves above this price. Because there isn’t a limit to how high a stock can trade, your potential loss is infinite.

However, when you sell to open a put naked, your maximum loss is the difference between the strike price and zero. In other words, stocks cannot trade below $0, so your potential loss is capped. This is the same downside risk as owning the underlying stock at the strike price.

Selling puts naked can be an excellent way to have long exposure to a stock at a better price. You may be eyeing a stock, but the stock always seems too expensive. Rather than chasing the stock price, you can sell a put, collect premium and become long the stock if it trades down.

For example, you may have wanted to own Microsoft (MSFT) during one of its market rallies, but paying more than $40 per share seemed excessive. Rather than pay that much, you could sell the MSFT March 35 Puts for $1.50. You collect money today, and your effective cost on MSFT if you are put the stock is $33.50 ($35 strike price minus the $1.50 collected).

In SlingShot Trader we won’t be selling puts, but if you are interested in this strategy, we strongly recommend that you start small. Get a feel on a personal level for what types of outcomes are possible. Make sure you’re investing only the amount of money you’re willing to lose entirely.

When you enter your options trades with your eyes wide open and realistic expectations, you’ll be better at managing your trades and, in turn, your risks. We strongly recommend that you only allocate 2% to 5% of your trading funds into each trade. That way, if the trade goes against you, you’re not going to lose your shirt and be unable to rebound from the loss.

Options-Trading Strategies: Buying Call Options

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”), 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. We recommended the Wells Fargo (WFC) May 48 Calls (WFC140517C00048000). We got into the trade at $1.27 and five days later sold to close the position at $2.42 making a quick 90.55% profit.

Ok, now let’s recap. The trade was a call option trade in Wells Fargo that May 19, 2014. We expected the stock to be approaching $48 or higher by the time it expired.

Options-Trading Strategies: Buying Put Options

In SlingShot Trader we’ll occasionally want to capture profits on the down side, 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 Halozyme Therapeutics (HALO) May 12 Puts (HALO 140517P00012000). We got into the trade for $1.40 and seven days later closed the trade for a 128.57% profit.

Below are the details of the trade broken down step-by-step. The trade was a put option trade in Halozyme Therapeutics that expired May 17, 2014. We expected the stock to be approaching $12 or lower by the time it expired.

Remember, options expire the third Saturday of the month, but since the market is closed, they stop actually stop trading the Friday before.

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 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 / by original investment

Here are a few examples.

Example A. You buy one contract of the Kellogg’s Sept 66 Calls 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 (.85 x 100*)
Divided by original investment 65/85 = .76 or 76%
*Each options contract controls 100 shares of stock.

Example B. Same Kellogg’s Sept 66 Calls 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 Divided by original investment
650/850 = .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 Kellogg’s Sept 66 Calls 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 $99 for 1 contract of the Kellogg’s Sept 66 Calls you bought at $0.85 ($85 + $14 commission fees = $99.)

$1,500 (150 per contract x 10 contracts)
 – $990 (99 per contract x 10 contracts)
$510 Divided by original investment
510/990 = .51 or 51%

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 it’s time to select a broker if you don’t already have one.

Choosing a Broker

Now that you have all of the ins and outs of options trading, along with our favorite strategy of credit spreads, 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.)

Option Approval

Each broker has different rates and requirements, but 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 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 spread trades. When you speak to your broker, we recommend you try to get approval for at least Level 2 so you can participate in the credit and debit spreads we will recommend.

We have found that not only are you spending less to get into the trades, but your profit potential can be huge. There’s nothing we like better than to get paid to put on a trade like you do in a credit spread. 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.

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. With this basic understanding of options, you can see how it can help you profit in any type of market.

This is a great reference that you will refer to again and again. With a little practice you’ll be trading options like a pro in no time. I’m looking forward to helping you make money trading options.

Signed John Jagerson Signed John Jagerson

John Jagerson & Wade Hansen
Editors, SlingShot Trader

Worksheets

Fill in the blanks

  1. A put is out-of-the-money when the strike price is ______ the market price of the underlying stock.
  2. If you bought 3 contracts of the Netflix (NFLX) June 95 Calls for $9.70 you would pay _____for the trade.
  3. You believe XYZ stock will continue to go up, so you buy the _______ option.
  4. A _____ option gives the buyer a right but not the obligation to buy a stock at a specified price during a specified time period.
  5. An option contract controls ________ shares.
  6. A ______ option gives you the right but not the obligation to sell a stock at a specified price
    during a specified period of time.
  7. The _________ _________ is the price at which the underlying stock may be purchased or sold by the option holder.
  8. A Call option is in-the-money when the strike price is ______the market price of the underlying stock.
  9. You buy an option at the ________ price.
  10. An option is at-the-money when the strike price is _____ to the market price of the underlying security.
  11. Define the following option symbol: WFM141122C00060000
    Underlying Stock (Options Root) = ______________(Whole Foods)
    Year = _____________________________
    Month = ____________________________
    Expiration Date =_____________________________
    Type of Option = ______________________________
    Strike Price = ________________________________

True and False

  1. You would need 7 options contracts to control 700 shares of stock in the
    underlying security? ____
  2. The options symbol WFM141122C00065000 is a put option? ____
  3. All option symbols are uniform with 21 characters. ____
  4. When you sell an option, it’s sold at the ask price? ____
  5. With options, you can profit in any market condition at a fraction of the cost of
    buying stocks. ____
  6. An option has more time value the further away it is from expiration. ____
  7. Option strike prices are based on the underlying stocks current price. ____
  8. If XYZ stock is selling for $60 per share, then an XYZ July 60 Call is in the money? ____
  9. You would be in-the-money if your stock is trading for $21 per share and you have the $25 call option. ____
  10. An option expires on the last day of the month. ____

Multiple Choice

  1. After this date your options will cease to exist and no longer be valid.
    For trading purposes it is the third Friday of each month. ____
  2. This strategy is used to protect yourself from a downturn in the market
    or to profit from a stock you believe is going down in the future. Your
    loss is limited to the amount you pay for the trade. ____
  3. What contains all the information on each option including: stock
    name, type of option month and date it expires along with many other
    details? ____
  4. An option is also known as this because as time passes it erodes the
    value. ____
  5. The benefits of doing these trades are many including: minimal capital
    outlay, leveraging your money, earning profits in a sideways, nontrending
    market, and the versatility. ____
  6. This strategy can be used when you want to “control” a stock but don’t
    want to own the stock outright and you expect the stock to rise. You
    have unlimited upside potential, but your loss is limited to the amount
    you spent on the trade. ____
  7. The price you can sell or buy an underlying security when you hold an
    option. ____
  8. When a put option’s strike price is above the market price of the
    underlying security and a call option’s strike price is below the market
    price of the underlying stock. ____
  9. Buy this type of option when you have a bullish outlook and believe the
    stock price will increase. ____
  10. Controls 100 shares of stock for each one purchased. ____
  1. Expiration Date
  2. Buying Puts
  3. Options Symbol
  4. Options Trading
  5. Wasting Asset
  6. Options Contract
  7. In the money
  8. Buying Calls
  9. Call Options
  10. Strike Price

Answers

Fill in the blank

  1. Below
  2. $2,910. Number of Contracts x Price per Contract x 100 3 x $9.70 x 100 = $2910
  3. Call
  4. Call
  5. 100
  6. Put
  7. Strike Price
  8. Below
  9. Ask. When you look at the options chain you will see two prices for each option: ask and bid. You buy at the slightly higher ask price and sell the option at the bid price.
  10. Equal
  11. Underlying Stock = This option is for Whole Foods
      Year = 2014
      Month = November
      Expiration Date = November 22. Remember, the market is closed on
      Saturday so the option will stop trading and expire on Friday, November 21.
      Type of Option = Call
      Strike Price = $60

True/False

  1. True
  2. False. This options (WFM141122C00065000) is a call option.
  3. True. On February 12, 2010, all option tickers were converted to a 21-character format. Each symbol contains the options root, year, month and date it expires, type of options (call or put) and the strike price.
  4. False. It will be sold at the bid price, which is lower than the ask price.
  5. True
  6. True.
  7. True
  8. False. The July 60 call is at the money when the stock is at $60. It would be in the money when the strike price is below the stock price — for example when it is at $55.
  9. False. If the stock is trading for $21 per share, your call option gives you the right to buy the stock at $25 per share. Since the stock is trading at a lower price, you are out-of-the money.
  10. False. For trading purposes, an option contract expires on the third Friday of the month.

Multiple Choice

  1. A.
  2. B. Buying Puts
  3. C. Options Symbol. Every options symbol has a uniform format so it can be universally understood by everyone in the markets. It contains the options root, year, month, expiration date, type of option and the strike price.
  4. E. Options are wasting assets because they expire and become worthless. As time gets closer to the expiration date, it erodes the value of the options.
  5. D. Options Trading.
  6. H. Buying Calls. This is also known as the “Long Call.” It gives you the right but not the obligation to buy the stock at a predetermined (strike) price in a set period (expiration date) of time.
  7. J. Strike Price. The strike price will vary depending on the amount of the underlying stock. Usually, if the stock is traded between $5 and $25, the strike price will be increments of $2.50. If the stock is traded between $25 and $200, the increments will be in $5. If the stock is trading over $200 the increments will be in $10, and occasionally for stocks under $50 you can have increments of $1.
  8. G. In the money.
  9. I. Call option. A call option is a bullish trade when you think the stock price will increase.
  10. F. Options Contract

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.

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 — 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 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.

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