Alright, now that you’ve read Options Trading (Where to Start?) which taught you how to create a watch list, do some research, and identify a few possible opportunities in the market you are ready “jump in” and start trading options. My goal, in this segment, is to help you maximize your return on those trades and help you avoid some of the mistakes I made in the beginning of my options trading career.
Calls or Puts?
When purchasing calls and puts the maximum amount you can l lose is the price you paid for the option contract. However, calls have an “infinite” upside, and the upside on a put is limited by the stock dropping to zero. Will a stock ever reach an infinite value? No. It is also unlikely that a stock will become worthless during the period of time that a put is held. Clearly, both of the extreme scenarios are unlikely, so let’s take a look at how the market has behaved historically to help in our decision making.
From 1926 to 2018 bull markets have lasted an average of 9.1 years with an annualized return of about 18.5%. During that same period, the average bear market lasted 1.4 years with an annualized loss of about 28%. In a broad strokes view, on average, you will have better luck making money on call options over the long term even though you could possibly make a higher percentage return if you were to time a put correctly. Obviously, individual stocks behave in a different manner from the market as a whole, depending on their Beta, but I believe this helps to represent the notion that positive market sentiment usually prevails even if it shouldn’t like in 2006 and early 2007.
That is why I only trade call options in this current market climate. As John Maynard Keynes once said, and I have personally experienced, “The market can stay irrational longer than you can stay solvent.” I’m not saying that you should never trade puts, but just be weary because it may take longer than expected for the market to come to the same conclusion you did and there is limited upside with puts.
What options to buy?
There are two main factors to consider when purchasing an option, the time until expiration and the strike price. Looking at the graph below on time decay, you can see that options with more time until expiration decay exponentially slower than options with less time until expiration. That is why I prefer to buy options with, at the very least, two months remaining until expiration, but more time is always better. If I still believe that the stock is undervalued once I reach the 30-day mark, then I will sell that option and move into one with more time remaining in order to reduce the amount of time value lost.
Next, let’s look at the strike price of the option. Below is a rudimentary graph that shows the time value as the stock price approaches the strike price. They height of the graph can change by factors like implied volatility, but it is always a bell curve where time value is maximized when the strike price equals the stock price. Therefore, I like to compare the price of the option closest to the strike price to the options, with the same expiration date, that are 5, 10, 15, and 20 percent “out of the money” (the stock price being below the strike price). Creating this rough time value curve helps me get an idea of the steepness of the curve at those points and I choose the option where an increase in the stock price will result in the greatest increase in time value.
When to sell?
The value of the option is comprised of the time value and the intrinsic value. We saw that time value is maximized when the stock price equals the strike price and decreases as the stock price exceeds the strike price. The intrinsic value of the stock is linear, with a slope of 1, and only exists when the stock price exceeds the strike price. Therefore, it’s best to sell the option before the decrease in time value has a slope greater than negative 1, and you can find this by creating a rough time value curve again. That is why I usually sell the option near the strike price because my return is near its maximum and the stock price is near where I think it should be, or if I believe it will increase a good deal more I will sell the option I have and purchase one with a greater strike price in order to have a greater return on that continued increase in the stock price.
Overall, after I have identified an opportunity, I purchase an option primarily for its potential increase in time value. This strategy takes less capital than purchasing shares of stock and can provide much higher rates of return. However, the daily movements are much more volatile and can result in greater losses on a percentage basis, which is why I don’t recommend trading options as your primary means of investing. I have been using this strategy over the past couple of years and it has proved to be profitable for me overall. The strategy will have to adapt once this changes to a bear market, but when it turns my losses will be limited to the price of the option.
In the Next Article
My next article will take a step back and go more in depth on identifying opportunities and valuation. In the meantime, I encourage you to give this strategy a try on some of the opportunities you have identified by creating a rough time value curve and “going long” on the expiration date.