As many have noticed our aggressive options strategy has a good performance record. Even with the trades we are currently in the percentage of wins with our options strategy is much higher than a typical swing or day trader in any market.
Many of the option strategies out there are complex multi leg strategies that are confusing. The purpose of this article is to provide a basic overview of options and why we use the strategy we do. Also some advantages or disadvantages it has over other more complex strategies.
We have three podcast you can listen to which go over our strategy and the 3rd podcast that goes over Debit and Credit spread strategies such as the butterfly. You can listen to them on our podcast page here. Do not forget this Saturday we have a special 1 hour podcast with Wild Bill as our guest. If you have any questions on long term investing or investing in gold and silver please email them to firstname.lastname@example.org with the subject “mail bag”, or our chat room will be live to take realtime questions during the radio show.
First some basic terms you should understand.
There are two options contract types Calls and Puts. Calls entitle the buyer “the right to buy” the underlying instrument, where a Put gives the buyer “the right to sell” the underlying instrument.
Like most contracts an options contract has an expiration date. The expiration date is the date the option contract expires. The buyer must exercise their option to buy before the market close on the expiration date. This is important to understand.
There are weekly options and monthly. Depending on the liquidity of the market will determine whether an instrument has only monthly options contracts or both monthly and weekly.
The standard stock options contract is for 100 shares. This is considered the contract multiplier or the quantity of the underlying asset that will be delivered in the event the option is exercised. 1 contract = 100 shares. 2 contracts = 200 shares and so on. There are other multipliers for certain instruments like Amazon which have “mini contracts” because of the price 1 contract = 10 shares.
The strike price is the price at which the buyer has the right to buy or sell the underlying asset. This is not the current price of the stock or instrument though a stock can be trading at or near a strike price. Depending on if a strike price is higher or lower than the current price of an instrument a stock is considered “In The Money” (ITM), “Out of The Money” OTM or “At the Money”.
The cost paid by the buyer, to the seller, for carrying the risk of being obligated to deliver on the contract upon expiration or exercise. The premium equals the Intrinsic Value + Extrinsic Value.
Intrinsic Value – The value of the option contract if it expired right now
Extrinsic Value – The value given an option contract due to time
The premium is the cost times the multiplier. Say the Apple Feb 8th 140 Put is trading at $3.0. If you want to buy the Put your cost is $3×100 shares or $300 is debited from your account. Selling is the same, but you receive the $300 as a credit to your account.
Say I buy a house at 100k today and it is worth 100k. If John Smith approached me to buy my house but did not want to take delivery or close until 2020, I would add a “time value” premium to the price say 10k. The intrinsic value is 100k (the current value) the extrinsic value is 10k (the time value). I want a premium for the obligation to sell my house in one year, and John would have to pay me a premium for the right to buy in one year.
So John, the buyer, would pay me 10k now, and we would enter a contract where the John has the right (not the obligation) to buy the house for 100k in one year when the contract expires. As the seller I have the obligation to sell the house. If the house is worth 120k in 3 months, John can exercise the contract in which I MUST sell it to him for 100k. I keep the 10k premium I collected so my total is 100+10 or 110k. My overall profit is 10%.
John may not want to take delivery of the house, so he could sell the contract to someone else for 25k since there is still 9 months left till it expires and there is some extrinsic (time) value to the contract. His initial 10k investment is now worth 25k. This is the lure of buying options.
However if the housing market tanks, and the house is worth 95k at the expiration date, John is not going to pay me 100k, yet I still keep the 10k he paid as a premium. John ends up taking a 100% loss. This is the downside to buying options.
Though I am obligated to sell him my house on or before the contract expires, nobody is going to buy a house for 100k if the value is only 95k. Since I collected 10k in premiums the actual cost I have into the house is 90k. I am still ahead 5k or 5%.
Let’s say the house is worth 112k a week before expiration. John can either exercise his right to buy at 100k and he has 2k immediately in equity, or sell me the contract back for 12k taking a profit of 20%. I would immediately roll it out another year and sell it to Sally for 22k for expiration in 2021, collecting another 10k in premiums (22k-12k). Then buy back the contract from John at 12k and sell it to Sally for 22k. I really have sold another year of extrinsic (time) value 22k-12k=10k.
In January of 2021 the housing market roars and my house is now worth 200k and Sally wants to close and move in. I am obligated to sell it to her at 100k but I collected 20k in premiums over two years. So essentially I made only 20% on the house, even though the value went up 100%. However if the housing market crashes and it is now worth 70k, Sally will just let the contract expire and I keep my house plus the 20k in premiums collected (10k from John and 10k from sally).
Doing the math, I paid 100k for the house, I collected 20k in premiums essentially reducing my cost to 80k, and though it is now only worth 70k, I only have 80k into the costs of owning. When the market returns and the house is at 100k again, I can look to sell options contracts collecting additional premiums.
This is our strategy in buying and selling options. The example here would be similar to a covered call where we own the underlying asset and are selling Call Options Contracts. The general rule here is only sell puts on houses you do not mind owning and calls on houses you do.
Stock Options Example:
Apple is trading at 152 and the below table is the option chain. On the left we have the Call options and on the right the Puts. This is a typical options chain and the highlighted strike prices are ITM. The Strike price is outlined in the middle and the outline to the left is the premium a buyer pays for the right to buy the stock at a specific strike price (Calls). The right is the premium a buyer pays for the right to sell the stock at a specific strike price (Puts).
The highlighted areas denote the calls and puts that are In The Money. If John thinks the price of Apple is going to go down further by Feb 8th he may look to buy a Put. There are two values associated with the premium John pays for the “option” to buy the stock the intrinsic value and the extrinsic value. Options out of the money have no intrinsic value. Options deep into the money have little extrinsic value.
The Feb 8th 144 Put costs $2.15 to buy. Since this is out of the money there is no intrinsic value and the stock has to reach 141.85 by Feb 8th for the buyer to break even. The closer we get to expiration the less likely Apple is to reach break even. The premium or extrinsic value moves lower. This is called “time decay”.
John buying one Put for Feb 8th expiration at the 144 strike pays $2.15 for the right to sell the stock at 144. The break even for the trade is the strike price plus the premium. So John needs Apple to be below 141.85 just to break even (144 – 2.15). This implies about an 8% move in the stock. Upon expiration if it is higher than 141.85 John loses money, if it is above John makes money.
If I am selling John the Feb8th 144.0 Strike I collect the 2.15 premium which I keep regardless of the stock price. If Apple does fall apart and moves to 140.0 at expiration, I simply allow John to sell me the shares of Apple at 144.0. This is being “assigned the contract” or I have to buy the shares from John. Now the broker does this automatically. The only thing you have to be aware of is if a contract expires in the money, you will be assigned the shares.
This means I must have 14,400 in cash or margin available to assume the stock as 1 contract is 100 shares @ 144.0 per share equals 14,000. Apple is a stock I do not mind owning, so I was literally paid 2.15 to buy the stock at 144.0. Now I either can keep the stock, or look to sell calls into strength.
Time is the Seller’s Friend
This is why time is on the side of the seller. I do not mind holding and am getting paid to hold. As a buyer time is your enemy, and if it does not move below the break even before expiration, you lose the premium you paid. As a buyer of options you can spend a lot of money, trying to hit a homerun. Take buying that same out of the money PUT at 144.0 and it moves to 134.00 by expiration. Here is your homerun, you paid $2.15 and the contract is worth $10.0 at expiration. Nice 400% profit, but how many losses do you incur to get that one homerun?
Time Decay is the rate of change in the extrinsic value as an option moves closer to the expiration date. In options this is called theta. We will not go over time value decay but just understand that the closer you move towards expiration the extrinsic value decreases faster.
Time Decay is most relevant when dealing with strike prices that are near the money, or out of the money. Volatility does play a roll in determining premiums, but time is the one thing options buyers have working against them.
The more volatility or price movement of a stock the higher the premiums. Tesla or Tilray premiums trade at a much higher price than say Cisco or XOM. The reason is price fluctuations and risks. If I am going to take the risk in an asset that has 10-20% price swings in a day, I want a big premium.
The risk in selling options is you are obligated to buy or sell the stock at the strike price on or before expiration. This is why it is important to manage your risk. So how do we manage risk with our “aggressive options strategy”?
We never sell a put option unless we do not mind owning and have the means to be assigned the stock. Some call this “cash covered”, or simply you have the cash to buy the stock if assigned. Let’s use our Apple example here and sell a Put slightly out of the money.
The Feb 8th Put 143 strike is currently trading at 3.30. Apple is currently trading at 152.0. If I sell the 143 strike at 3.30 I am obligated to buy the stock at 143 on Feb 8th. However the purchaser of the option is NOT obligated to sell them. I in return receive 3.30 per share or $330 per contract to take on this risk.
I have to be prepared to be assigned 14,300 worth of Apple stock if at the expiration date, Apple is at or below 143. This is the risk. Let’s say it is at 140 @ the market close on the 8th. I am going to be assigned 100 shares at a cost of 143.0 per share. I must have 14,300 in cash or margin available to acquire the shares.
The broker states your risk is $14,300 as Apple can go to zero and you are still obligated to buy the stock at 143.0. This is true but the risk is pretty much the same if you buy 100 shares of Apple outright at 152.0 where if the stock goes to zero you paid $15,200 for it.
We never sell naked Calls!
Selling naked calls can destroy your account period. We only sell covered calls which implies we own 100 shares for each contract we sell.
Why don’t we sell naked calls but we do sell naked puts?
If we sell a naked put our risk is still limited to the strike price x 100. So if we sell a $7 Put for Feb 8th expiration on NBEV and the stock goes to 0.01 we are obligated to buy the stock for $7 and our risk is $700.
If we sell a naked Call for Feb 8th expiration at the $7 strike and Coca Cola buys NBEV for $25 a share, we on the 8th of February we will be buying 100 shares at $25 and selling them at $7 for an $18 loss per share. Since there are 100 shares per contract we lose $1800 per contract. Say Pepsi starts a bidding war and the shares rocket to $50. We lose $50-$7 or 4300 per contract. We see this often in Bio-tech stocks.
If we own 100 shares of NBEV and we sell the Feb 8th Call at $7 collecting $1 in premium and the stock rallies to $100, well we simply let our shares get called away. We only lose our shares. This is called a covered call. The downside is we did not make all the money we would have if we did not sell Covered Calls.
There are other strategies that allow you to minimize risk without owning the shares which are all variations of credit spreads or verticals.
We sell Puts on stocks we do not mind owning, and collect the premium. If a stock ends up ITM at the expiration date we take delivery of the shares (assigned). Now we own 100 shares of this stock. When the stock rallies we will sell covered calls in lieu of selling. Again we collect a premium to sell our stock and if it ends up ITM we simply allow them to be called away.
Often when selling OTM Puts or Calls the option expires worthless and the reason buying options is generally a game in which you are trying to hit a homerun. Look at Apple for example. The 140 Put Strike is trading at $1.20. What are the chances of Apple going to 140 by Feb 8th or lower?
The question really should be who is buying options? There are three reasons to buy options.
#1 you are hedging a current position like buying a Put after a large rally.
#2 you have inside information that a stock is going to rally or fall apart
#3 you are a retail investor looking to hit a home run, the typical gambler
Who is selling options? Well that is simple, market makers, brokers/dealers, and large institutions. So do you think the option premiums are priced to make money for the retail investor? Not a chance. Now to be clear there is risks in selling options but if done correctly and with managing your risks the potential to create consistent income is there.
Lets go over a recent options trade we did with MPC which went through the entire strategy.
Marathon Petroleum is a stock I do not mind owning for the long term and do own in my long term portfolio. During pullbacks I like to add to my position, but in lieu of adding outright with just buying the stock, I decided to sell the Dec14th Put with a strike price of 60.50 for $1.50.
As typical it jerked around the price and was slightly ITM so we rolled it out another week collecting another $1.60 and buying back my previous Put for 64 cents. I simply now collected $2.54 in premiums for a stock I did not mind owning at 60.50.
By the 21st of December MPC had pulled back more and the contract was well in the money. I simply allowed the stock to be assigned to me at 60.50. AT this point I now own 100 shares of MPC, but collected 2.54 per share to buy it. When the stock rallied back up to the 60.50 price I sold Covered Calls for Jan 11th Expiration at the 61.50 strike price for $1.00. It continued to rally and on the 11th it was trading around 65.0 so I simply let the shares get called away at 61.50.
In essence I bought 100 shares at 60.50 and sold them at 61.50 and collected $351 in premiums. So overall my profit was $451 (not including fees). This $451 is now allocated for buying MPC shares. I can simply now buy around 6-7 shares of MPC and have no cost into them.
Now the risk is the share price moves lower such as our AMD trade. Let’s take a look at this one and again we do not mind owning the stock.
Here it is not all roses and candy and you must be able to take some pain along the way, no different than seeing the housing market fall apart and you are upside down in your home. The strategy of course is the same, you wait it out.
AMD is one example of a trade we took some pain in originally but are clawing our way back into the money.
We initially sold the 26.0 OTM Put for 1.40, however going into earnings is risky. We mentioned to our members that if you can not take the pain of seeing a pullback to 17-19 then close out the position. Well AMD did just that and pulled back to 17.0 after earnings that were simply not good enough.
We took assignment of the stock at 26.0 which seems painful, but becomes less painful the more often it happens. Since then we have sold Covered Calls twice and collected an additional 1.60 in premiums. So we own the stock from 26.0 which is our break even, but we have collected 3.00 in premiums as well. Overall our average cost per share is 23.0.
We will continue this strategy until the stock is called away and the premiums collected will be ear-marked for AMD.
What makes our strategy different:
We us technical analysis and a combination of fundamentals, swing and position trading technical analysis to determine which equities we take trades in. We look for swing setups on companies we like fundamentally, and enter position trades in the form of selling options.
Technical analysis is as much apart of our strategy which is based on position trading. We just do not blindly sell options. The upside is using technical analysis and our options strategy has a higher success rate than swing trading.
We are not just trading random stocks or trying to hit homeruns. We are looking for stocks that will return consistent gains using this strategy. Sounds easy right? Well it is not as simple as it looks.
There are risks involved and you must have the patience and the ability to ignore short term losses taking pain often. In addition, there are specific things we look for when trading options like volatility and premium costs. Deciding which strike level to sell and at what premium can be the difference in having a MPC or AMD.
Our overall goal is to have the trade expire worthless, which is good for sellers. Often we are assigned and this requires the capital to handle assignment. This is why risk management is crucial.
Verticals Credit and Debit Spreads:
Another way to reduce risks of selling or minimize costs in buying is Debit and Credit spreads. We will go over these in a separate article. This is the basis for many of the other strategies there are out there such as butterflies, condors, synthetic longs and short etc. Our recent podcast went over these strategies and why we do not use them often.
One challenge with these strategies is the additional fees you pay to enter them. In addition, you are giving up some profits to implement these strategies. This can lead to lower returns in the long term. This is why we opt for a simple strategy and not more complex ones.