Our goal is to explain stock options in simple English. As you learn more, you will appreciate how difficult a task it is. People say that investing in stock is like playing checkers, while investing in options is like playing chess. We look forward to teaching you how to play the more complex game of stock options.
Are Stock Options Risky?
Most people would answer that question with a resounding "yes". True, according to some studies, over half of all options that people buy end up being worth absolutely nothing. Nada! Tear up your ticket stub and walk away.
If buying options is such a bad investment, maybe a strategy of selling options to someone else would be a better idea. Let their loss be your gain. But there is a problem here as well - it is called selling a naked option, because that is how you feel for the whole time you have sold that option. You are facing a theoretical unlimited loss. You can lose many more times the amount you invested. At least when you bet on a horse, that is all you lose when he trips on his way to the finish line.
So if buying options is usually not a good idea, and selling them can be worse, it is easy to see why people decide that options are risky no matter what you do. It does not occur to most of them that a strategy of buying an option and simultaneously selling another option to someone else might be an entirely different story.
This website is designed to explain an options strategy that we believe is less risky than buying stock or mutual funds, and potentially a whole lot more profitable. We hope you will read through this material and learn to love the world of options as we do.
Why Trade Stock Options?
Stock options are exchanged for two main reasons: for speculation (adds risk) and for hedging (reduces risk).
Speculation
Stock options are a way of leveraging your money. This is usually done by buying call options. You are able to participate in any upward moves of a stock without having to put up all the money to buy the stock. However, if the stock does not go up in price, the call option buyer may lose 100% of his/her investment. For this reason, options are considered to be risky investments.
Hedging
Stock options can be used to considerably reduce risk. Put options are usually traded for hedging purposes. While hedging reduces risk, it also limits the amounts of gains you can make. Since most stock markets go up over time, and most people invest in stock because they hope prices will rise, there is more interest and activity in call options than there is in put options.
As its ticker symbol implies, Salesforce.com (CRM) provides cloud solutions for customer relationship management needs. CRM reported earnings in late August that blew away expectations on both the top and bottom lines. The report was met by the usual round of target price increases that reached as high as $340 (CRM closed at $260 on Friday).
The stock gapped higher after the report and extended as much as 5.5% higher the next day, eventually closing with a 2.5% gain. But the shares then sagged, joining the rest of the market in the early-September swoon. In fact, CRM fell more than 8% from its post-earnings high.
But the shares appeared to find a bottom last week, thanks to the support of the 50-day moving average. Since turning higher in May, the 50-day has supported pullbacks in July and August. CRM has been stepping higher since a low in early March, putting in a series of higher highs and lows in a rally that has covered nearly 30%. This trade is relying on this trendline support holding for the next six weeks, as the short 250 put of our credit spread is just below the 50-day.
Sell to Open CRM 29Oct 250 put (CRM211029P250) for a credit of $1.10 (selling a vertical)
This credit is $0.02 less than the mid-point of the option spread when CRM was trading at $260. Unless the stock rallies quickly from here, you should be able to get close to this amount. Your commission on this trade will be only $1.30 per spread. Each spread would then yield $108.70. This trade reduces your buying power by $500 and makes your net investment $391.30 ($500 – $108.70). If CRM closes above $250 on October 29, both options will expire worthless and your return on the spread would be 27% ($108.70 / $391.30).
Copart (CPRT) provides online auction and vehicle remarketing services in the U.S. and several other countries. On Wednesday, the company reported Q4 earnings that easily beat on the top and bottom lines. Used car prices are soaring and CPRT is positioned perfectly to leverage the market. Analysts seem to agree, as CPRT received several target price increases that ranged up to $165 (CPRT closed at $143 on Friday). Despite the positive news, the stock fell as much as 5% on Thursday before closing 2% lower. However, CPRT gained more than a percent on Friday amid a down market.
The stock has been in rally mode since late March, gaining more than 30%. The 50-day moving average has been instrumental in guiding the uptrend, containing pullbacks in May, June and August. The trendline appears to be doing its job again, as it supported this week’s post-earnings drop. This trade is relying on this support holding for the next five weeks as the short 140 put of our credit spread is just below the 50-day.
If you agree that CPRT will stay above the 50-day moving average (red line in chart), consider the following trade that relies on the stock remaining above 140 (blue line in chart) through expiration in five weeks.
Buy to Open CPRT 15Oct 135 put (CPRT211015P135)
Sell to Open CPRT 15Oct 140 put (CPRT211015P140) for a credit of $1.20 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when CPRT was trading at $143. Unless the stock rallies quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $118.70. This trade reduces your buying power by $500 and makes your net investment $381.30 ($500 – $118.70). If CPRT closes above $140 on October 15, both options will expire worthless and your return on the spread would be 31% ($118.70 / $381.30).
Software developer (QuickBooks, TurboTax) Intuit (INTU) reported earnings on Aug. 24 that handily beat estimates on all fronts. Earnings came in at $1.97 per share, topping the analyst forecast by 24%, while quarterly revenue of $2.56 billion beat the estimate by 10%. The company also raised its quarterly and annual revenue and earnings guidance above expectations. To top it off, INTU raised its dividend and approved a new $2 billion repurchase authorization.
The Street clearly loved the report, as the stock was hit with several large target price increases (one raised the price 27%). The average new target price after these raises was around the $640 mark, which is 13% above INTU’s closing price on Friday.
The stock price took the news and target increases in stride, though, with no change on Thursday after the report. On Friday, the stock resumed its huge rally with a 2.4% gain. INTU is up nearly 50% in 2021, with most of that gain coming in the past 3-1/2 months. The shares have been riding along their 20-day moving average, a trendline that has not allowed one daily close below it since mid-May. The 20-day is currently at 541 but should cross above the 550 level in less than two weeks at its current pace. This is also the site of the short put strike of our credit spread.
If you agree that INTU will continue its rally along the 20-day moving average, consider the following trade that relies on the stock remaining above 550 through expiration in seven weeks.
Buy to Open INTU 15Oct 540 put (INTU211015P540)
Sell to Open INTU 15Oct 550 put (INTU211015P550) for a credit of $2.80 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when INTU was trading at $566. Unless the stock rallies quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $278.70. This trade reduces your buying power by $1,000 and makes your net investment $721.30 ($1000 – $278.70). If INTU closes above $550 on October 15, both options will expire worthless and your return on the spread would be 39% ($278.70 / $721.30).
Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad
This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).
Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.
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Options are not suitable for all investors as the special risks inherent to options trading my expose investors to potentially rapid and substantial losses. Please read Characteristics and Risks of Standardized Options before investing in options
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