Four Must-know Rules To Profit From Options
Whether youre a novice options investor or youve been trading options for years
, four simple rules could mean the difference between serious gains and major losses. Heres everything you need to know to go from optionless to an options whizEvery day, scores of novice options investors get burned. Its not because theyre bad investors, its simply because theyre not following the rules. Theres no question that options are tricky it can take years to learn precisely how options work but that doesnt mean that understanding the options game is out of reach, or that its relegated to the big guys on Wall Street.
Despite their complexity, theres plenty of reason to pay attention to options. Options provide incredible amounts of leverage with relatively limited downside. That leverage means that a relatively small increase in a stocks share price can turn into a potentially huge gain in an option for that same stock. Just look at shares of the ProShares Ultra S&P 500 ETF (NYSE: SSO), a 5.3% climb in that stock over the course of just two days in July turned into a 28% profit for investors who bought one strike of that funds September call options.
Put these four must-know rules into play, and your chances of booking profitable options plays increase exponentially
1. Think About Value, Not Just Price
Most people think that options prices (also known as premiums) are tied to the prices of their underlying stocks, but thats not entirely true. Like stocks, options trade on the open market, which means that technically, options investors themselves set the prices of options through their
bid and ask prices.
That doesnt mean that youll see an option trading way out of line with its underlying, but its certainly not uncommon to see examples of options prices that dont mesh with what their values should be.
Thats because unlike a mutual fund or ETF, which is priced based on the value of its assets right now, options take extrinsic variables, like the time value of money into account. There are a number of ways to value an option, including the Black-Scholes model and the Monte Carlo method, but if you want to avoid the mathematical formulations, most financial websites and trading platforms can come up with an option value almost instantly. Use that price as a starting point when you decide if an option is worth your time.
2. Dont Get Greedy, Use Goals
Hogs get slaughtered. No, thats not some sort of farmyard to-do list, its a phrase Wall Streeters use to remind each other and themselves that greed is the fast track to serious losses. Its all too common for investors to hang onto a winning position too long, hoping for a few extra points, only to see those gains reverse themselves. Thats especially true of options, where a position can swing from a double-digit gain to a serious loss overnight.
Now, that doesnt mean that you should sell your positions off as soon as youre up more than 5% goals are the secret to beating this pitfall. Get a grip on greed by setting your target gains before you enter a position, and stick with them unless something fundamentally changes in the underlying stock.
3. Take One Play a Week
The only way to make money on options is to play them and to keep making options plays, even if youve just picked a loser. After your first bad trade, its incredibly easy to give up and just stick to stocks. But thats a huge mistake. The only way to learn how to use options profitably is to use them often, so always try to make a new trade every week.
If moneys the issue, it shouldnt be. There are scores of paper trading platforms out there many of them free to use that let you make hypothetical trades without risking your real-life capital. Trading paper for a while can help build your options investing skills until youre ready to put your cash back on the line.
When deciding on which paper trading platform to use, its best to go with a broker. Many brokerage firms (including Thinkorswim, Scottrade, and optionsXpress) will let you test-drive their actual trading platforms with a practice trading account. Using the real platform means that the gains you get in the virtual world will mirror the gains you can expect when you switch to real money and it also means that youll get used to your brokers software and tools.
4. Understand Options Greeks
When you hear traders talk about the Greeks, they dont mean Plato or Socrates.
Theyre talking about the series of calculations that are used to determine the value of options. The calculations are designated by various letters of the Greek alphabet, from which they get their name.
On our agenda today is delta.
Every option, whether call or put, has a delta attached to it. Generally you can find this information on your brokers Web site.
A call has a positive delta, and a put has a negative one.
If an option is at the money, usually the call option will be a delta of +.50 and the put option will be -.50.
Thus, if the GBP/USD is currently trading at 1.6400, the 1.64 call option has a delta of +.50 and the 1.64 August put option has a delta of -.50.
As the pair moves up in value (that is, the sterling appreciates against the dollar), the sterling calls will increase in value. As of this writing, they are trading at $2.51 x $2.63. With the delta at +.50, that tells us that for every penny the sterling increases in value (which would be measured as 100 pips), the option will increase 50 cents. Thus the delta is the measure of the rate of change in the value of the option as compared to the value of the underlying asset.
The reverse is also true. If the spot price fell 1 cent, or 100 pips, the value of the put option would increase by 50 cents.We also have another inverse relationship to consider. If we are holding put options and the spot price increased, the value of the put option would FALL by 50 cents. Same is true of the call. A 100-pip or 1-cent decrease in the underlying spot price would make the option fall by 50 cents.
So if the pound is at 1.6400, and we are looking at the August 1.64 calls, lets say we go ahead and we buy them right now at $2.63 ($263). We believe the sterling is going to rise and the options are going up in value. If the spot price goes to 1.6500, we can expect the call option to move up 50 cents in value to $3.01 x $3.13, giving us a return of 38 cents per position.
However, at that level, the delta has changed (actually it always changes as the price changes, but for the sake of simplicity we wont go into that detail). At this point the delta is nearly +.60. So now for every cent the spot moves up, our option will increase by 60 cents. By the time that the call option is deep in the money, it will have a delta of 1.00. That means that for every 100 pips, or 1-cent move, in the spot, the option will move a corresponding 100 cents. The same is true for a deep in-the-money put. It will eventually reach its maximum delta of -1.00, at which point it will move in lockstep with the spot price.
How does this help us? Mainly in terms of entries and exits that we would like to plan in advance.
You Have Options
Theres no question that investing in options comes with a steep learning curve. That said, profitable options plays dont have to be a faraway goal. Invest in options using these four rules and youll be well on your way to seeing profits from your calls and puts.
Cheers,
Bill Jenkins
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