In Part 1 of Trading Options Like a Pro we covered what options trading is, how it sits in terms of strategy and one of the basic options strategies: selling Covered Calls on stocks you already own.
There are several reasons why we have written about “Selling” or “Writing” options first as a strategy and we want to take you through those in turn so that you can understand the market we are in today.
Buying Options – Caution in Volatile Market
You COULD buy call and put options and predict the future direction of stocks. Let me give you two examples, that help highlight the serious risks of this strategy during periods of higher than normal volatility (like now).
Example 1 – Buying Tesla at the Top
If you bought Tesla call options at the end of August when the stock was trading at $490-$498, a TSLA Mar 19 ’21 350 Call option would have cost you about $160. That means you gain money if the price of Tesla stock goes above $350 by 19th March 2021. Right?
Wrong. Spending $160 on a Tesla call option (as above) means that your breakeven price for making money is $510 (350 strike price + premium paid). Call option buyers at the end of August were forecasting absurdly high stock prices for Tesla that were very, very risky. As of today that same option is now worth $122. This equates to a -23.8% loss on the value of the contract, and a -15.3% loss for the underlying Tesla stock. If Tesla doesn’t hit $510 by 19th March 2021 you’ve lost money even if Tesla hits above $350.
Example 2 – Buying Tesla options at the Bottom
Well, on 8th September Tesla stock hit $330. It had fallen -33.7% in the span of 9 trading days and those who had been speculating on Tesla options probably got cleaned out. However, assuming you were patient and you waited for a sell-off before buying any options, what would have happened if you purchased a call option on 8th September at the absolute bottom?
The Mar 19’ 21 350 Call options actually hit a bottom around 24th September at $98. If you had purchased at the absolute bottom, given today’s option price of $122.36, you’d be sitting on a “paper” profit of +24.5%. The problem here is this profit is STILL premised on a $448 price for Tesla by 19th March 2021 ($350 strike plus $98 premium paid). You’d be prudent to consider selling as the profit margin increases. To be honest, it isn’t a huge profit.
Why we want to Sell options – Buy Stocks for Cheap!
As with many things with finance, the more you peel back the layers of the onion, the more you realise that the basic things you were taught don’t – in the strictest sense – really apply.
According to the CME and a three-year study of options contracts from 1997-1999, 76.5% of the options contracts studied expired worthless. The study also found that if you look at Put options alone, which are designed to bet against stock prices, the figure is even higher: 82.6% of those options expired worthless for the US, European and Japanese stock indexes.
To put it simply (no pun intended): on average, do you want to spend your time BUYING contracts with premiums that can be quite high, when on average they expire worthless 76.5% of the time?
There is a statistical edge to being what I would call a Market Architect. You are inside the system “printing off your own options” for agreed premiums that YOU receive in exchange for doing so. If you sell a Put, you’re simply agreeing to buy that stock at a set price. When you factor in the premium you receive often your “breakeven” point is much lower than the current price of the stock.
Selling a Microsoft Put with March 2021 Expiration
Let’s give a clear example with one of our recent stock tips: Microsoft.
On the 3rd of September when volatility reached 33.6, I decided that the market sell-off had reached a crescendo. Investors were panicking and in fact we were still destined for a continuation of the recovery:
The S&P 500 index was 3455 on 3rd September, and is now sitting at 3348. However because I know that options contracts track Volatility (VIX above) and not price, I decided to be bold and Sell/Write options against Microsoft.
Here is how I did it. I checked out the options tables on Yahoo and looked to see what the premiums were like for Microsoft. Here is a graph from my Interactive Brokers account:
I could see that on 3rd September MSFT Mar 19 ’21 200 Put had a premium of $22.25. This means that if I became a Market Architect and sold that put into the market, I would receive $22.25 per share. For 1 options contract (which represents 100 shares of Microsoft) I would receive $2225 as a premium upfront.
With my 100 shares of Microsoft (valued at about $20k) I rang up my broker and stated I wanted to “Sell a Put” on Microsoft with a strike price of $200. This means that I am willing to purchase 100 shares of Microsoft at any time between now and 19th March 2021, from the option buyer. In return I receive $22.25 per share, or $2225 for the 1 put that I sold. Straight into my brokerage account.
How I Calculated my Profit/Loss Position
What’s awesome is that with my iPhone and very basic calculations, I understand exactly what I was entering into. It’s a powerful trade that works very well when the market is selling off and you’re willing to buy a stock at slightly lower than its current stock price.
If Microsoft stays above $200 a share for the entire time between now and 19th March 2021, then the option will expire worthless. I received $22.25 per share as a premium. So I effectively pocket a 10.85% profit on today’s shares for doing literally nothing, except entering into a contract. Remember: this 1 put that I sold obligates me to buy MSFT IF it drops below $200 and gets exercised. If it doesn’t drop below that level, I keep the premium.
If Microsoft dips below $200 a share but never gets below $180 a share, then in all likelihood the option buyer will not exercise the option (to force me to buy 100 shares). Provided that Microsoft recovers to at or above $200 by 19th March 2021, the option expires worthless and I pocket the premium. But let’s say it hits $200 exactly. There is no point in exercising it really so more often than not it expires worthless.
If Microsoft drops below $179.75, then the option buyer on the other side of the “Put” that you sold into the market may very well exercise the option. They are “in the money” and because the stock price is lower than the strike price ($200) they have the right to ask you to take the shares. In this scenario I am quite happy to own Microsoft, even if it keeps falling to $150-$160. To be honest it is a brilliant company so I will hold onto the shares and pay $200 for them. Remember this though: my BREAKEVEN price is $179 ($200 – $22.25 premium + $1.25 fees).
Frugal Investors Conclusions
This is a powerful and not-very-well-known trade. Platforms like Robinhood and Tastyworks have tremendous advantages to the market and they are great places to trade options. The problem is that they confuse people with the ability to quickly execute complex trades. To be honest, in today’s market and up until the election, you should almost exclusively be focusing on selling covered calls and puts into the market and benefitting from the premiums on offer.
Hopefully though this is educational for you & helps you to understand the risks and benefits on offer by selling options into the market! Best of luck to the budding Market Architects out there.