Let’s talk about options! What are they and how can you use them to make huge profits, double and triple digits per trade. And as a bonus at the end of the post, I will show you how IRS will treat insanely favorably your earnings. I used to manage billions, especially in the option space. I share with you my professional investor’s experience.
You can also watch my video “Options: Trade and win! Understand how options work!” on my YouTube’s channel. Check it out!
Before we start, I am not giving financial advice, and this video is not a solicitation to buy or sell any security.
What can you achieve with options?
Maybe you already heard of options, or even you traded options in the past. In this post, we will have a short overview of what options are. I am a specialist in the subject since I have traded them for many years as a portfolio manager. I think there will be a lot of posts on the subject. I wish to give you the keys to invest better and make thousands of dollars in profits. And who knows maybe soon you will make tens of thousands, then hundreds of thousands, and perhaps millions.
Am I overly optimistic? Maybe a little. But you’ll see that embedded in options there is leverage and played well, you can achieve huge returns. But do not forget, as with all financial products, there are risks to manage.
So what is an option? An option is a derivative product. It means that the price of an option is driven by something else. It can be a stock, an index, a commodity, a bond. For stocks, the relationship is usually direct. For indices, commodities, and bonds, the relationship goes through another derivative product, a future.
What is a future?
Very briefly, a future has a direct relationship with its underlying asset. You can see a future as a promise to buy or sell something in the future at a specified date. For example, instead of buying a stock, you could buy a future. The difference between buying the stock and the future is that when you buy a stock, you pay the full price, and when you buy a future, you deposit only a fraction of the price, the initial margin.
Where can you buy options?
Options are instruments that are traded both on exchanges and over-the-counter, also called OTC. As an individual, you will never trade any OTC financial product. Over-the-counter is for big boys: banks, insurance, funds, some big industries. Exchange-traded options have standardized characteristics, but when a sophisticated player wants to trade something more tailor-made for its need, he has to find another player who wants to take the other side of the deal, and voila, an OTC option is born.
What does an option do?
An option allows you to buy or sell another asset, like a stock, at a predetermined price in the future, but you may choose not to do it if you are the option buyer. If you are the option seller, you have to do what the buyer wants, so selling options is riskier.
For example, you buy an option that gives you the right to buy Tesla at 250.
An option to buy something is called a Call.
What are the possible outcomes? Let’s imagine the price of the stock rises to 300. You buy it anyway for 250 thanks to your option. You have a lovely 50 dollars profit. You see for any Tesla’s price over 250, you buy it anyway for 250, making a profit. This explains the straight line going up on the right side of the graph; one dollar increase in the stock price makes you one dollar profit.
Why? Because the option seller has no choice, he must sell it to you at the agreed price, called the strike price.
So how do you agree on the strike price? It is easy you buy the corresponding option. For example, let’s go to marketwatch.com, and let’s see options. There is a lot of figures, don’t be afraid you will understand everything, the strike is the middle column. As I said, exchange-traded options have standardized features. You choose the option that closely matches your investment goals. As you can see for each stock or any other financial asset, there is a lot of options to choose from.
Now, imagine the price drops to 200 instead of going up, would you exercise your option to buy it at 250 anyway? I bet you wouldn’t. Congratulation! You now understand how options work.
So on the left side of the profit and loss graph, there is a flat line! You will not exercise your option, and you let it expire worthless.
Why did I say “expire”? Because one characteristic of options is that they have a shelf life, after that they expire. For example, for the same strike price, you can choose an option that expires in August or a lot of other months. And in a month you can have options that expire at different dates. On August 13, 2019, we have the 16th, the 23rd, and the 30th. When an option expires, either it is profitable or worthless, and it disappears.
Let’s come back to the option profit and loss graph. Do you see what is wrong with this picture?
Why on earth the option seller sell options? If you reverse the graph, to see things from his perspective, he sees only a loss or nothing at best!
Can you guess what is missing? Yes, buying options is not free! Options have a price, and it is called the option’s premium.
Let’s look now at the corrected profit and loss graph. It shifts downward to reflect the premium you pay if you are the buyer:
And for the seller, it moves upward:
So as an option buyer, your risk of losing money is limited to the premium you paid. Here we have the right to buy something if we want, it is a call option. For calls, your upside is unlimited, if tesla stock goes through the roof, so is your profit.
On the flip side, the seller of a call has a limited profit, but potentially an infinite loss. This is why selling options is a risky business.
Imagine you were able to buy this option for a premium of $10, the stock is at 300, you have $50, so a 500% increase. Since the premium can be small, and you can make a way larger profit, this is how options allow you to make double or triple-digit profits.
True story, I have seen options bought by a colleague for one cent, then worth 80 a few hours later. He purchased an insane amount of those, but for one cent it didn’t cost him much. He made an 8,000% profit, can you imagine that. Just think about it, let’s say a $1,000 order, worth after a few hours $80,000.
Okay, we talked about options to buy something, but sometimes you maybe want to be able to sell at a higher price if the asset’s price is below. It is possible, with put options.
Let’s look at the graph of the profit and loss of a put option, for example, a put option on Tesla at 250.
More the price of the stock goes down; higher is your profit. Let’s say Tesla goes down to 200. It means you can buy the stock at 200, sell it immediately at 250 by exercising your put, and make $50, less the premium you paid for the put.
Your loss on a put at maturity is limited to the premium you paid. The profit is at best the strike price less the premium paid. Why the strike price? Because at best for you put buyer, the stock goes down to 0, and you earn the difference between the strike and 0, which is the strike price.
For the put seller, it is the reverse. Limited gain, up to the put’s premium, limited loss up to the strike price less the premium collected.
Don’t let the limited loss of the put seller fool you. Usually selling puts is considered more dangerous than selling calls. Why? Because prices tend to go down sharply and quickly when something is wrong with the asset. On the upside, usually, prices go up slower, leaving more time to the seller of calls to adjust his position. However, there are always exceptions. A stock can gain 20% in a day; it happens. It may also depend on the asset; puts are more dangerous usually for stocks and indices. But for currencies, calls and puts are equivalent in term of risk. And for an asset called VIX, it is selling calls that is sheer madness if you do not know what you are doing.
So if you start trading options, buying them is the safest way to start. In following posts about options, I will talk more about strategies involving buying and selling options together.
Now when can you exercise your option? It depends. Some options allow you to exercise them early, anytime you want up to the maturity. Other options allow you to make that decision only at maturity. By the way, if an option is profitable at maturity, it will be exercised for you.
An option that you can exercise any time you want, up to the maturity is called an American option. An option that can be exercised only at maturity is a European option.
Calling options American or European has nothing to do with where they are traded. You have American options in Europe and European options in the U.S. It is just a naming convention.
Options on stocks are usually American, both in Europe and America. Options on indices are generally European, both in Europe and America too.
Can you buy an option on only one share of a company’s stock? No, ordinarily, options are traded with a contract or lot size, for example, 100 for most stocks. Even if the stated price of the option is for one share, you will trade by 100 units. If the option’s price is $1 on your screen, you pay $100 to buy it, because one equity option contract represents 100 underlying shares of a company’s stock.
One last thing today, for options on stocks, when they are exercised the stock is delivered to your brokerage account, it is called a physical settlement. If you are the option seller, shares are taken from your account. On indices or other assets where the physical delivery is difficult, there is a cash settlement. You receive on your account your profit or pay your loss.
Now bonus time: If you trade futures, futures options, and broad-based index options, you need to be aware of Section 1256 contracts defined by the Internal Revenue Code. Any gain or loss you have from a 1256 Contract is treated for tax purposes as 40% short-term gain and 60% long-term gain, regardless of the holding period. Options on S&P 500 are that kind of contracts. So even if you buy options and sell them 10 minutes after, making a considerable gain, let’s say $10,000. You will be able to claim that $6,000 are a long term gain, with a lower tax rate.
To summarize what we have seen: Options are a way to buy and sell an asset at a predetermined price in the future, the strike price. They expire at a maturity date. You can exercise European options only at the maturity, and you can exercise an American option early any time up to the maturity date. Options on stocks are American options, with a physical settlement, and options on indices are European, and they are cash-settled. You trade options by contact or lot size. And finally, with options, you can achieve multi-digit returns.
I am eager to read your comments, your questions, and your suggestions.