One common financial myth is that holding stocks for years is the only way for everyday investors to succeed in the market. While this is a profitable strategy, there are other ways to reach your financial goals. One of the most powerful — and most misunderstood — strategies is stock options. With options, you can achieve returns multiple times higher than a simple buy-and-hold strategy. You also don’t have to wait until retirement to realize your profits.
This is the first guide in my series on how to multiply your profits with stock options, aimed at beginners.
Table of Contents
- Dispelling Myths about Stock Options
- Too Complicated
- Too Risky
- The Basics
- What are Options?
- Terminology
- Leverage and Super-Sized Profit Power
- Stock Options vs. Stock Shares
- Greater Potential for the Same Initial Cost
- Call Options are Like Coupons
- Intrinsic Value
- Extrinsic Value
- Time Value/Decay
- In-the-Money (ITM), Out-of-the-Money (OTM), and At-the-Money (ATM) Options
- The Effect on Premiums
- Understanding Risk
- Exercise an Option or Close it Early?
- Advantages and Disadvantages to Both Choices
- Margin
- Risks of Naked Calls
Nearly Everything You’ve Heard About Stock Options is False
Stock options have a bad reputation. Most people see them as too risky or too advanced for everyday investors. Neither are true.
I admit that at first glance, options are confusing. They have their own vernacular, and broker platforms look like spreadsheets hopped up on a dozen espressos. Like most things, however, once you learn the basics, options become fairly simple.
If you understand how to trade stocks, you can understand stock options.
I believe that the mystique surrounding options is intentional. As long as Wall Street can convince you that options trading is best left to professional money managers, they can keep charging exorbitant fees. My hope is that by the time you finish reading this, you’ll realize that if you understand how to trade stocks, you can understand options.
What about risk?
It all depends on how you trade options. There are risky strategies, but there are also very conservative plays. It’s similar to stocks. If you trade penny stocks, you’re taking on colossal risk. But if you invest in a blue chip company like Coca-Cola (KO), you’re virtually assured to profit over time, even if it’s a small profit over a very long time.
The Basics: What are Stock Options?
Stock options are a type of derivative. They derive their value from the price of a company’s stock, which is called the underlying. Therefore, the price of an option will change when the underlying price changes.
Options get their name from being just that—an option. When you buy an option, you are entering a contract that gives you the option to buy or sell a stock at a certain price. A concrete example will make this easier to understand.
To make the math simple, let’s pretend that Apple’s stock is priced at $100. Let’s also say that you think that price is too low. You believe that within the next 30 days, Apple will trade for at least $110. So, you buy 5 shares for $100 each for total cost of $500 (5 shares x $100). If you’re correct, you’ll be able to sell each of your 5 shares for $110 giving you a total profit of $50 (sale price of $550 ($110 x 5) minus your $500 cost basis = $50). That’s a 10% gain in a month, which is a fantastic return over such a short period of time!
But now imagine you use options. The same scenario applies. Apple is selling for $100, but you think it will be worth at least $110 in 30 days. Instead of buying one share, you can buy a call option. This gives you the option — but not the obligation — to buy Apple’s stock for $100 at any time over the next 30 days.
Since an option is a contract, there is someone else on the other end who is selling you that call option. That person is legally obligated to sell you Apple for $100 regardless of how much the stock price actually is. That’s right. Even if the share price rockets to $250, you will still pay only $100!
The profit power of stock options comes from leverage.
Let’s build off our previous example. Imagine Apple’s stock rises to $110. Because you bought the call option, you will only pay $100 for the stock. The seller is obligated to sell it to you for that price. (Your broker automatically enforces this. You don’t have to do anything.)
At any time over the length of the contract (in this case, 30 days) you can exercise your option. This means that the seller’s shares will be called away (that’s why it’s called a call option), and she will have to sell you them for $100 each. You can then immediately sell those shares on the open market for $110 for a cool 10% profit.
But wait…how is this any different than buying shares of Apple stock?
It comes down to leverage. Leverage results from using borrowed money to multiply your buying power and therefore increase the potential return on your investment. Don’t worry. It’s not as scary or risky as it sounds because we can control the risk up front. I’ll explain this later.
With stock options, one contract represents 100 shares. Since options use leverage, you control 100 shares of a company’s stock for just a fraction of the cost of buying those shares outright.
Let’s return to our Apple example. You decide to buy one call option for a strike price of $100. The strike price is simply the price at which the option contract can be exercised. In this case, as long as Apple trades for at least $100, you can exercise the contract.
By purchasing one call option, you control 100 shares of Apple. If you were to simply buy those shares, it would cost you $10,000 (100 shares x $100 each).
But what if you could control the same amount of shares for just $500? That’s only 5% of what it would cost you to buy the shares outright ($500/$10,000). You can do that with options!
20x buying power for the same price
Remember, in our first scenario, you bought 5 shares of Apple for $100 each for a total investment of $500. With options, that same $500 gives you control of 100 shares! That’s 20x the amount of shares for the same up-front cost.
Look at how this plays out in our pretend scenario. You bought one contract of a 30-day call option with a strike price of $100. Apple’s stock price rises to $110, so you exercise your option contract. The seller is obligated to sell you 100 shares of Apple for $100 each even though the open market price is $110.
You buy those shares and then immediately sell them on the open market. This nets you a profit of $1000. Here’s how we get that number:
You exercise your option, which means you buy 100 shares for $100 for total of $10,000. You immediately sell those 100 shares on the open market for $110 each giving you a total sale of $11,000. Your sale price ($11,000) minus your cost basis ($10,000) nets you a profit of $1000.
Buying Stock Options vs. Buying Stock Shares
Now let’s see how that compares to simply buying shares. When you did that, you invested $500 up front and finished with a profit of $50. Using stock options, however, that same $500 up-front investment resulted in a profit of $1000!
Again, that’s a 20x greater profit for the same initial cost!
Before you rush out and buy some call options, however, there are a few more things we need to cover, especially the associated risk.
Although the above example is theoretically how option trades play out, they rarely go that way in real life. It is very rare for a trader to exercise his options. Here’s why:
Every option has a price. In our pretend Apple example, I said that your initial cost would be $500. In your trading platform, the buy price would actually be listed as $5. Remember, one contract is equal to 100 shares. That’s why your purchase cost would be $500 ($5 x 100).
When you trade options, you’re actually buying or selling the contract not the underlying shares. The contract itself has value and a marketplace.
Think of it this way. You own a contract that says that the holder is entitled to buy shares of Apple for $100. But let’s say that Apple is trading for $110 on the open market. The contract that you own is therefore worth at least $10. Why? Because if I bought that contract from you, I could immediately make $10. The contract lets me buy shares for $100, which I would then sell for $110.
This might be easier to understand if we think of an example that has nothing to do with stocks.
Call Options are Like Coupons
Imagine that a concert ticket costs $20, but you own a coupon that says you can buy that same ticket for $15. Instead of attending the show, you decide to sell your coupon. If you price it for anything less than $5, your buyer is getting a deal.
For example, I could buy your coupon for $4 and still come out ahead. I would spend $4 for the coupon, which allows me to buy the actual ticket for $15. That’s a total cost of $19 — $1 less than if I bought the ticket from the venue.
That’s how options contracts work. You essentially hold a voucher that lets you buy Apple’s stock for $100 regardless of the current market price. That voucher (contract) therefore has intrinsic value as long as Apple trades for more than $100. For example, if Apple trades for $105, the contract you hold has an intrinsic value of $5.
But there’s more. That contract also has extrinsic value. Since the stock can continue to rise, it has value in addition to its current price. Let me explain:
If Apple is selling for $105, but you think that its price is going to climb to $110, the stock has an additional value of $5 to you. It has an intrinsic value of $5 because you hold a call option for $100, and the stock is currently priced at $105. You could sell it for $105 right now.
But it also has extrinsic value because the stock can continue to rise over time, which would give you even more profit. That’s how options contracts are priced:
Intrinsic Value + Extrinsic Value = Option Price/Premium
Extrinsic value can be a little tricky, so let’s use another non-trading example.
Imagine that your family owns two vehicles. I offer to sell you a voucher for gasoline for $100. This will allow you to fill up your cars’ tanks as many times as you’d like over the next 30 days. That’s a great deal, right?
Let’s say that it costs $40 for you to fill up each of your cars with gasoline. After 3 fill-ups, you have made money off your voucher purchase. You would have paid $120 to fill up your cars. Since you bought the voucher, however, it only cost you $100.
There’s more. Every time you get gas from this point forward, you also “profit” because you get the fuel for free. If you fill up again, you save another $40.
Now let’s imagine that 28 days have passed, meaning the voucher expires in 2 days. Your cars’ tanks are full, so you don’t need the voucher any more. Rather than throw it away, you decide to try to sell it.
Would you be able to sell it for the same $100 that you purchased it? Probably not.
For someone to be willing to buy that voucher, she would have to know that she was going to buy at least $100 of gasoline over the next 2 days. If she is going to spend less than that, she should just buy fuel at the service station. In other words, your voucher has less value as it gets closer to its expiration date.
Notice that the only difference in this situation is time. You still have 2 cars, they still cost $40 each to fill up, and I’m still selling you the same voucher for the same price. The key detail is the amount of time remaining.
This is called time value or time decay, which is another way of referring to extrinsic value. If you buy an option, the value of that option decreases over time. This is because the stock has less time to rise to your target price. In other words, your option has less extrinsic value.
With stock options, time really is money.
Time value is vital to pricing options. In general, the more time you have before expiration, the higher premium you will pay. The premium simply refers to the amount that you have to pay for an option. Remember, one option contract represents 100 shares. So, if the premium is $5, that is $5 per share. Your cost will be $500.
Intrinsic Value + Time Value = Option Premium
In addition to the amount of time remaining before expiry, implied volatility (IV) has a significant impact on the price of an option. IV represents how much the market believes the underlying stock price will move. The more volatile a stock is, the higher the IV will be, which results in a higher premium.
All trading platforms will display the IV of an option. You can even compare that number to its historical (usually 12 months) volatility. Most stock options are priced using the Black-Scholes model. If you are a math person, you can read more about that here. For trading purposes, however, you just need to know that the higher the IV, the higher the premium.
In-the-Money Options vs. Out-of-the-Money Options.
The last terminology that I’ll cover here is in the money (ITM) and out of the money (OTM). An ITM option means that the option has intrinsic value. For a call option, this means that the underlying is currently selling above your strike price (if it’s selling at your strike price, it’s called at the money (ATM)).
Let’s say you bought a call option with a strike price of $100, and the stock is currently trading at $102. Your option is ITM. It has an intrinsic value of $2 because you could exercise your option and immediately sell the stock for more than what you paid for it.
Conversely, if an option is OTM, its intrinsic value is $0. If you bought a call option for $100, and the stock is trading at $95, that option only has extrinsic value. This is because you need the stock to increase at least $5.01 for you to be able to sell it for a profit.
Since OTM options do not have any intrinsic value, their premiums are lower. Their risk is also greater, however, because unless the underlying price increases, the option will expire worthless. More on that below.
Understand the risks
Buying call options can reap enormous profits. Theoretically, your profit potential is unlimited because the price can increase infinitely. As with any type of investment, however, there are risks.
When you buy a call option, you expect the price of the underlying to increase. But what if you’re wrong?
If your option expires and the underlying stock is below your strike price, your option is worthless. Let’s return to our imaginary Apple scenario to see why this is so.
You bought a call option with a $100 strike price and an expiration date 30 days from now. Those 30 days pass, and Apple is only trading at $95. Your option will expire worthless. Why? Because it doesn’t make any sense for you to exercise your option. Doing so would cause you to buy the stock for $100. There is no reason to do that if you can buy the same stock on the open market (a regular share buy) for $95.
When you buy a call option, and it expires OTM, you lose your entire premium. In our Apple example, you paid $500 for the call option. Since that option is now worthless, you lose all of it.
This situation is why many people consider stock options too risky. Compare this to if you simply bought 5 shares outright. You would have paid the same $500 to buy those shares. If the price of the stock dropped from $100 to $95, you would lose money, but not all your money. You would only have a loss of $25 ($5 per share x 5 shares).
So, while buying a call option has far greater profit potential than simply buying shares, the amount you can lose is also multiplied.
By now, you may be thinking, “See! Options are too risky!”
Sure, if you lock in a trade and hold on no matter what, you’re taking on big risk. There are simple ways to manage that risk, however.
First, you don’t have to lose all your money. Just like with owning shares, you can close your option at any time before the expiration date. Option prices fluctuate throughout the day just like stocks. If you decide that you no longer want to hold the option, you can sell it. This will allow you to recoup some of the premium you paid.
For example, let’s say you bought a call option for $500. It’s 10 days before expiry, and that option is now only worth $250 because the underlying dropped below your strike price (i.e. your option is currently OTM). You can hold that option and hope that it rebounds. Or, you can give up and sell it for $250. You will still lose money but not all your money.
Second, when you buy an option, your risk is clearly defined up front. You can only lose your premium.
All options platforms will tell you what your maximum loss is for each trade. In other words, you know in advance exactly how much you can lose. That information will help prevent you from risking too much of your portfolio on one trade. Remember, since the maximum gain on a call option is theoretically infinite, you don’t have to risk much to realize a large profit.
Should You Exercise Your Option or Close it Early?
The last risk we need to discuss involves exercising a call option. This isn’t much of a risk, however.
If you exercise a call option that you bought, it means that you call away shares from the seller. Let’s look at an example:
Imagine that you buy one call option of Apple with a strike price of $100. This gives you the option (but not the obligation) to purchase shares for $100 regardless of what they’re selling for on the open market.
Let’s pretend that on the day of expiry, Apple’s shares are selling for $110. If you choose to exercise your option, you will buy 100 shares (remember, one option contract controls 100 shares) for your strike price of $100. That will cost you $10,000 (100 shares x $100 each). You could then sell those shares on the open market for $110 or hold onto them for as long as you choose.
You will rarely, if ever, exercise a call option.
I have personally never exercised an option. That’s because in nearly every case, you will make more money if you don’t exercise your option and simply close it out instead.
How is this possible? It comes back to the concept of time value.
Remember, if you bought a call option that is ITM and there is still time before expiry, your contract has both intrinsic value and time value. In this scenario, Apple may be selling for $110 right now. But if the option doesn’t expire until next week, there is still time for it to climb higher.
Therefore, if you closed your option today, you would make a profit off the $10 intrinsic value ($110 market price minus $100 strike price) plus the time value/extrinsic value. The latter mount will vary depending on a number of factors, but it will be worth something.
Now imagine that you instead hold until expiration, and Apple’s shares are selling for that same $110. The difference is that since the option expired, there is no time value remaining. Therefore, you will only earn a profit consisting of the $10 intrinsic value. That is why option traders nearly always close out their trades before expiry.
Capturing both intrinsic value and time value earns higher profits than exercising the option and buying shares at the strike price.
This is one of the biggest differences between stock options and shares of stocks. If you buy shares outright and immediately sell them, you’ll make a profit, but you will not capture any extrinsic value. There is no such thing as time value when buying/selling shares. That value only comes with options.
It’s also worth noting that most brokerage firms will auto-exercise an option after expiry if it is at least $0.01 above the strike price. Fortunately, there are ways to protect yourself from inadvertently exercising your options. Your broker will alert you when you hold ITM options and the expiration date is near.
Subscribers to The Antagonist will also receive email alerts for trades that I’ve recommended. I usually close my trades 4–15 days before expiration (assuming they didn’t already hit my profit target, in which case I would have already closed them). This strategy lets me capture both intrinsic and extrinsic value while also preventing me from inadvertently exercising my option.
When to exercise your option.
All that said, there may be occasions when you decide to exercise your option. The first reason is that you may want to own the shares outright and hold them long term. Since your trade is ITM, you’ll be able to buy those shares at a discount.
Another reason is to capture a dividend. You can exercise your option, buy the shares at a discount, receive the dividend, and then either sell the stock or hold it.
Note that in both of the above cases, you must have enough cash on hand to buy the 100 shares at your strike price. In our example, that would cost $10,000.
That’s another reason why most traders don’t exercise their ITM options. They either don’t have enough cash on hand, or they don’t want to spend that much one stock.
That’s the beauty of stock options. You can earn the same profits of owning 100 shares (or more) of a company without actually buying those shares!
Leverage is the key.
This is all made possible through the power of leverage. Recall that leverage results from using borrowed money to multiply your buying power. You receive that leverage through margin. Margin is the money you borrow from your broker to purchase a security.
That may sound scary, but it’s not. First, if you’re buying a call option, there is zero debt involved. Nor will you pay any interest fees because your broker will require you to pay the premium in full in cash. This is also how you will know your max loss before placing a trade. You can only lose what you paid for your premium.
In the case of buying a call option, think of it as your broker spotting you some credit. They know that you are likely to close out your ITM option. So, they only require a fraction of the money that it would cost you to buy 100 shares outright. In our Apple example, that’s how you could control 100 shares for only $500.
Moreover, my trading strategy does not lead to any debt or interest payments. You will need to open a margin account, but that’s only because that’s the type of account required (instead of a cash account) to trade options. You’ll also need Level 3 approval, but I cover that in another article.
Phew! Thanks for reading this far!
I know this was long, and your head is likely swirling from information overload. The good news is that nearly every options trade is based off the concepts that I covered in this issue. It will now be much easier for you to learn the strategies that I most often use and recommend in The Antagonist.
Please note that while buying naked call options (the strategy described in this article) can result in enormous profits, they are also risky.
The only time that I buy a naked call is when I feel very confident that the underlying stock will rise quickly. I also risk a much smaller amount of money than I do with other strategies and instruments.
Again, the purpose of this issue was to provide you with foundational knowledge. Over the rest of this series, I’ll cover how to get options trading approval in your brokerage account, how to profit from options when you think a stock is going to decrease or move sideways (i.e. selling/writing call options), and my favorite strategy: vertical spreads.
Don’t miss out on educational articles like these and other content. Subscribe now to get The Antagonist delivered to your inbox.
Happy trading,
Jason Milton