There are two sides to every story and I believe that becoming successful in this world depends entirely on learning which side of a given story to be on. The option world is no different.
What truly infuriates me is the public perception of option traders: you must be crazy to trade options. Option trading is not investing. It’s just too dangerous to trade options. Never trade options with your retirement money. The constant negativity surrounding option trading is never-ending and heaven forbid you bring it up to your broker or money manager.
I’m here to tell you from someone who has done it and has experience that option trading, if done correctly, with knowledge and respect, is not nearly as risky as the world would have you believe. It is an investment strategy just like mutual funds, money managers and dividend stocks. It’s a vehicle to get you from where you are to where you want to be just like anything else.
However, if used correctly, options can get you there much faster…
THE BUYER (YOUNG, AMBITIOUS, DUMB)
Most rookies in the option trading world gravitate towards being the buyer. I am no different and just as guilty. It appears easy and offers the potential to make crazy returns with small amounts of capital. The illusion of being a buyer will suck you in for sure, but it is just that – an illusion.
Yes, I have made a significant amount of money as the buyer. I have made average annual salaries in a day as the buyer. I have also LOST annual salaries in a day – in the blink of an eye. The option buyer must be fearless, active, have a sixth sense and watch his every step all the time. Sound fun? It can be, but it can drive you insane as well. The buyer must have extreme confidence in himself and his ability to spot trends.
The reason being the buyer is an illusion is really simple: it’s cheap so anybody can do it, but more importantly, no one really appreciates or understands the value of time. Time, as the buyer, is your enemy. It’s worse than kryptonite to Superman. It’s worse than regular gasoline for a BMW – the really cheap shit you might find at a gas station right off a half-ass highway between Town Creek and Rogersville, AL – yes, a personal experience.
As the buyer, Time Decay is the most important element in the transaction. Upon execution, at that very second you hit submit, the clock is ticking – tick tock, tick tock. With every second you’re losing money. Time Decay immediately creates an uphill battle that does not end until the moment you sell to close. If you’re wrong about the direction of the underlying you either lose money and get out, wait for a bounce and still lose more money and get out because with each day you’re in you’re losing more and more, or keep “buying down” your cost basis by pouring more and more money into the option praying for a bounce. Wait too long and not even the greatest rally ever imagined can save you because by expiration, no matter what, your option is worthless.
Ok, ok, it’s not quite as bad as I’m making it out to be, but almost. I have bought down and bounced out of many transactions quite profitable. I have bought CALL options only to watch their lifecycle and one time I was up 223% on a Starbucks CALL option and didn’t sell it because I had intentionally bought it to watch and learn the life of an option. How it grows, how it dies and how long does it take. All very important as the buyer. I eventually sold that CALL option negative 30%…
As the buyer you, the trader, must be 100% sure about the direction of the underlying stock. Not only do you have to get the direction right, you have to get the timing right as well. In any market this is difficult. In today’s market it’s damn near impossible.
There is a reason why people say option buyers make money only 35% of the time. If you think about it, it makes perfect sense. The market will always trade one of three ways: up, down and sideways. As the buyer you must choose up or down and BE RIGHT. If you’re wrong about the direction you lose money. If you’re wrong about the timeline you lose money. If the underlying stock just sits there for a month and does nothing (trading sideways) you lose money – see a pattern? Why does the buyer lose money more times than not? Time decay. Why does the buyer typically make money only 35% of the time?
Because the buyer only makes money one out of three directions.
Is there a reason to ever be the buyer? Yes. Absolutely. Back in January 2016, just a few weeks ago, Facebook announced quarterly earnings and took off. A $1000.00 CALL option, as the buyer, would have made 50k. There is always time to be the buyer, but my rule is: only use the houses money because you will more than likely lose it and only try when you believe 100%, on your mothers grave, in what is about to happen.
THE SELLER (OLD, JADED, WISE)
Where do I begin…the seller is the man. He’s the old guy in the corner sipping hundred year old scotch with all the money. He owns everything and he loves to see buyers walk in the door thinking they’re better than he is or they’ve found the path to riches. He was once the buyer, but he grew up.
Why are there not more sellers? This one is easy too, but you’re not going to like the answer: money. It takes money to be the seller. No way around it. It takes either owning a great deal of stock or having the cash to back up your play. Once funded, however, you can make returns unlike anything you’ve seen before.
What’s so great about being the seller? One simple, yet incredibly important fact: time is your friend. The fact all options decay over time works in the sellers favor. Yes, that’s right, as the option decays in value the seller profits no matter what happens. I often tell people, as the seller you either make money or you make money and get what you want. That’s about it. There is no real downside. Another way to look at it: you are the lender as the seller, not the consumer (I give Hillary credit for that one, thank you dear).
Let’s use a real world example. Say you are dying to own Ford stock. You have $100,000.00 to invest and you open a brokerage account to start buying stock. Unfortunately, most amateur investors end up buying high and watching the stock go lower. Then they sit on it, hopefully collecting a dividend because you never buy stocks that don’t pay dividends, and wait for the stock to appreciate. Average transaction.
An option seller would approach it completely different: the seller, knowing he had cash to spend, would SELL CASH-SECURED PUTS against Ford. If the seller felt $12 was a fair market price he would be willing to pay for Ford stock he would sell the $12 strike PUT for a premium of let’s say $2,000.00 for this example. IF Ford did nothing and sat there for a month (his option expires in 30 days) the seller would keep the 2k and start all over after expiration. IF Ford dropped below the $12 strike AND he was assigned a buyer he would keep the 2k AND get the shares of Ford he wanted in the first place. Unlike the average buyer he received Ford shares at a discount AND got paid to wait. IF Ford went up the seller, again, keeps the 2k premium and at expiration starts all over.
As you can see the seller makes money regardless. The seller also never incurred any risk. Read that again – the seller never incurred any risk! Why? Because he wanted the shares anyway. He already had the money waiting. He made the premium regardless. There was no risk. If the option DECAYED all the way to expiration the seller still keeps the premium. If the seller is exercised he gets the stock and the premium. Time decay is in the sellers favor. See what’s happening? How cool is this??
RULES OF BEING THE SELLER
Rule # 1: Only sell PUTS against stock you really want to own. If you’re selling against something you want to own anyway, then the “risk” of getting exercised is irrelevant. You would WANT to get exercised so you get the shares “PUT” on you for the strike price. In other words, you would buy the shares from the buyer at the agreed upon price.
Rule # 2: Based on the above, you would want to choose a strike price you are comfortable paying for the stock if exercised. If you are not comfortable paying the strike, don’t make the transaction.
Rule # 3: If your account is small or you’re just starting out, choose a longer expiration and fewer contracts. If you have tons of money and want maximum returns sell large quantities of contracts for short expirations. Rinse and Repeat.
Rule # 4: Watch for market sentiment for the stock you want to own. There are “sweet” spots for being the seller and you want maximum premiums. For example: if Starbucks is trading at 57.50 and has been going down for a week the PUT premium for the 57 strike will be pumped higher. This is a good time to sell the 57 strike PUT especially if that’s as low as Starbucks gets and then it jumps a dollar and hovers. Perfect. You got maximum money for the option and as it trades sideways after the jump the time decay works its magic.
Rule # 5: Never give up the premium. You hold the option until expiration no matter how badly you need the margin, want what profit you do have or whatever. You hold until it expires and keep the entire premium. No Excuses.
Rule # 6: Most important saved for last: never be the buyer.
So you’re ready to be the seller…now what do you do? Here is a short list to help:
- Don’t listen to anybody or what they say about trading options. Block it out.
- Do not pay attention to the Greeks and valuations, it will only confuse you more. The seller doesn’t really have to worry about any of that stuff.
- Create a brokerage account and enable option trading. This can be complicated and some brokers require a great deal of paperwork before allowing you to trade options. Ask now and get everything ready.
- Create a list of stocks you want to own and start watching.
- You need stock shares or cash. No way around this. If you have stock shares already (over 100) you can start selling CALL options – otherwise known as “covered calls” since they will be covered by shares you already own. You may be tempted to sell “naked calls” or calls that are not backed by shares you already own. Do not do this – ever. You can get into serious trouble. If you do not own stock now, the only choice you have is to save money and sell PUTS for stock you want to own. Period.
Option trading takes action and doing to really understand. I can type all night, but a rookie trader will need to perform a few trades either with real money or paper money to truly get it. It will start clicking after the first few transactions.
Remember: selling PUTS is a BULLISH move. The seller of a PUT will make money if the stock goes up or trades sideways. Selling CALLS is a BEARISH move. The seller of a CALL will make money if the stock goes down or trades sideways.
Sometimes that’s hard to visualize at first because it’s opposite from the buyer.
A buyer will purchase a CALL option if he thinks the stock is going up and a PUT option if he thinks it’s going down.
I hope this has been helpful and I’m really trying not to make it complicated. There is a great deal of information that goes along with trading options, but my point is to feed you only what you need to know. Good luck! I would love to hear stories about success and failures.
Drop me a line if you have a story or question.