If you've been wary of getting into options trading because you don't know where to start, this story is for you.
Last week I introduced you to options trading, the elements of options and how to use "put" options effectively to lower your portfolio's overall volatility. Here we will dig deeper into options trading and how to place an options trade, how to choose a strike and expiration date, and why options have great leverage over stocks.
The basic options overview or montage (series of option strikes) can be seen on pretty much any trading platform, such as those offered by TD Ameritrade, Fidelity and Charles Schwab. For our purposes, we'll use the TD Ameritrade platform and options overview for Microsoft (MSFT) . On this platform and on most platforms, we can see option strike prices and expirations all compiled in one neat area. In the options overview below for Microsoft, there are monthly and weekly expiration dates. Monthly strikes always expire at the market close on the third Friday of a month. Weekly strikes expire every other Friday. There are some daily and mid-week expiration dates for index options as well, but they are not available for individual stock names. There really is no difference between monthly and weekly expiration dates other than a monthly strike typically has larger open interest, or the available amount of contracts to trade.
In the Microsoft montage above, there are strike prices, expiration dates, volume and open interest, along with the bid-and-ask for specific options. Calls and puts are separated; calls are on the left and puts are on the right.
We select options in dimensions of price and time. Which option we select depends on our analysis and expectations for the stock to move in a certain direction. The closer a strike price is to the current trading price of the stock (this is "at the money") or into the price of a stock (this is "in the money"), the more expensive an option is. Using the Microsoft montage below, we see that the stock is trading at $287.42. A $280 call (to the left) expiring on May 19 would cost approximately $14.25. This cost is called the "premium". The ask price is $14.05 and the bid price is $14.25. The ask is the price the seller is "asking" for in exchange for selling the option contract, and the bid is the price the buyer "bidding" or willing to pay for the option contract.
The spread between the bid and ask is rather narrow for Microsoft's May $280 call. This tells us there is a very liquid market for these options. More proof of that is in the open interest, which shows more than 7,800 contracts are open. Since each option contract controls 100 shares of stock, we can infer this 7,800 open interest controls 780,000 shares of Microsoft stock, just this one strike alone.
Liquidity is important as it allows us to enter and exit a trade without too much difficulty, as option market makers are willing to step in and encourage a transaction.
A buyer of one Microsoft May $280 call at $14.25 would pay $1,425 since each contract represents 100 shares of the stock. Therefore, the cost of one contract is the option contract price x 100.The premium (the cost of the option contract) is made up of the intrinsic value and time value or time decay. What is intrinsic value? Simply put, intrinsic value is the difference between the current stock price minus the strike price. So, with Microsoft stock at $287.42, the Microsoft May $280 call has intrinsic value of $7.42.The remaining $6.83 of the option cost is the time value or time decay. Because the Microsoft May $280 call will not expire for 1 month from now, the option seller will ask the option buyer to pay for that time. This is time decay.
As the buyer of this option you must be aware of where the breakeven point is at. How do we find it? We take the option strike of Microsoft May 280 call and add the premium (which is the paid cost of the option), which equals $294.25. This would be the mathematical breakeven price at expiration - the price the stock must be at on expiration for the buyer to break even. Indeed, any price above this level would be profits to the buyer when the option is sold or exercised.
This is where option leverage comes into play. Let's say before the May expiration we see Microsoft trades at $310 per share, a spectacular move higher. The stock would have gained 7.85% over this period of time from when we first bought the Microsoft May $280 call. But how much is our option worth? It is now worth $30, and at a cost of $14.25 we have more than doubled our purchase, or up 110%. The option return is 14 times better than the stock return during this period. In addition, the buyer only needed to put forward $1,425 to control 100 shares of Microsoft via one contract option rather than $28,742 to control 100 shares of stock.
Now, if Microsoft does not rise above $294.25, we can incur losses. For instance, if Microsoft can only get to $290 by the May expiration date, our Microsoft May $280 call is only worth $10, and we sustain a loss of 29.8%. But we can only lose the premium we pay and nothing more, since options are a cash only transaction (no margin allowed). That 29.8% loss seems rather steep, but buying the option for 5% of the price of stock turns out to be a better-leveraged trades than just buying the stock outright. If an option is out of the money, say Microsoft falls to $270 a share then the option value deteriorates quickly, and at expiration the value of the option is nil or zero.
One more thing to keep in mind. About 80% of all option contracts expire worthless. Be mindful of managing your risk. Basically, risk what you can afford to lose and not putting all of your capital on the line.
(MSFT is among the holdings in the Action Alerts PLUS member club . Want to be alerted before AAP buys or sells stocks? Learn more now. )
