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All About Stock Options

My goal is to give you a basic understanding of what stock options are all about without hopelessly confusing you with unnecessary details. I have read dozens of books on stock options, and even my eyes start glazing over shortly into most of them. Let’s see how simple we can make it.

Basic Call Option Definition

Buying a call option gives you the right (but not the obligation) to purchase 100 shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the third Friday of a specific month (called the expiration date).

People buy calls because they hope the stock will go up, and they will make a profit, either by selling the calls at a higher price, or by exercising their option (i.e., buy the shares at the strike price at a point when the market price is higher).

Basic Put Option Definition

Buying a put option gives you the right (but not the obligation) to sell 100 shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the third Friday of a specific month (called the expiration date).

People buy puts, because they hope the stock will go down, and they will make a profit, either by selling the puts at a higher price, or by exercising their option (i.e., forcing the seller of the put to buy the stock at the strike price at a time when the market price is lower).

Some Useful Details

Both put and call options are quoted in dollar terms (e.g. $3.50), but they actually cost 100 times the quoted amount (e.g., $350.00), plus an average of $1.50 commission (charged by my discount broker – commissions charged by other brokers are considerably higher).

Call options are a way of leveraging your money. 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 option buyer may lose 100% of his/her investment. For this reason, options are considered to be risky investments.

On the other hand, options can be used to considerably reduce risk. Most of the time, this involves selling rather than buying the options. Terry’s Tips describes several ways to reduce financial risk by selling options.

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. From this point on, if I use the term “option” without qualifying whether it is a put or a call option, I am referring to a call option.

Real World Example

Here are some call option prices for a hypothetical XYZ company on February 1, 2010:
Price of stock: $45.00

Expiration Date  
Strike Price Feb ’10 Mar ’10 Jan ’12 Terminology of Option
(price of call option)  
40 $5.50 $7.00 $18.50 “in-the-money”
(strike price is less than stock price)
45 $2.00 $4.00 $16.00 “at-the-money”
(strike price is equal to stock price)
50 $0.50 $1.00 $14.00 “out-of-the-money”
(strike price is greater than stock price)

The premium is the price a call option buyer pays for the right to be able to buy 100 shares of a stock without actually having to shell out the money the stock would cost. The greater the time period of the option, the greater the premium.

The premium (same as the price) of an in-the-money call is composed of the intrinsic value and the time premium. (I understand that this is confusing. For in-the-money options, the option price, or premium, has a component part that is called the time premium). The intrinsic value is the difference between the stock price and the strike price. Any additional value in the option price is called the time premium. In the above example, the Mar ’10 40 call is selling at $7. The intrinsic value is $5, and the time premium is $2.

For at-the-money and out-of-the-money calls, the entire option price is time premium. The greatest time premiums are found in at-the-money strike prices.

Options that have more than 6 months until the expiration date are called LEAPS. In the above example, the Jan ’12 calls are LEAPS.

If the price of the stock remains the same, the value of both puts and calls decreases over time (as expiration is approached). The amount that the option falls in value is called the decay. At expiration, all at-the-money and out-of-the-money calls have a zero value.

The rate of decay is greater as the option approaches expiration. In the above example, the average decay for the Jan ’12 45 LEAP would be $.70 per month ($16.00/23 months). On the other hand, the Feb ’10 45 call option will decay by $2.00 (assuming the stock stays the same) in only three weeks. The difference in decay rates of various option series is the crux of many of the option strategies presented at Terry’s Tips.

A spread occurs when an investor buys one option series for a stock, and sells another option series for that same stock. If you own a call option, you can sell another option in the same stock as long as the strike price is equal to or greater than the option you own, and the expiration date is equal to or less than the option you own.

A typical spread in the above example would be to buy the Mar ’10 40 call for $7 and sell the Mar ’10 45 call for $4. This spread would cost $3 plus commissions. If the stock is at $45 or any higher when the options expire on the 3rd Friday in March, the spread would be worth exactly $5 (giving the spread owner a 60% gain for the period even if the stock stays the same – less commissions, of course).

Spreads are a way of reducing, but not eliminating the risks involved in buying options. While spreads may limit risk somewhat, they also limit the possible gains that an investor might make if the spread had not been put on.

This is an extremely brief overview of call options. I hope you are not totally confused. If you re-read this section, you should understand enough to grasp the essence of the 4 strategies discussed in Terry’s Tips.

Further Reading

Two more steps will help your understanding. First, read the Frequently Asked Questions section. Second, Subscribe To My Free Options Strategy Report, and receive the valuable report “How to Create an Options Portfolio That Will Outperform a Stock or Mutual Fund Investment”. This report includes a month-by-month description of the option trades I made during the year, and will give you a better understanding how at least one of my option strategies work.

Stock Option Symbols

In 2010, option symbols were changed so that they now clearly show the important fearure of the option – the underlying stock that is involved, the strike price, whether it is a put or call, and the actual date when the option expires. For example, the symbol SPY120121C135 means the underlying stock is SPY (the tracking stock for the S&P 500), 12 is the year (2012), 0121 is the third Friday in January when this option expires, C stands for Call, and 135 is the strike price.

Stock LEAPS are one of the greatest secrets in the investment world. Hardly anyone knows much about them. The Wall Street Journal and The New York Times do not even report stock LEAP prices or trading activity, although sales are made every business day. Once a week, Barron’s almost begrudgingly includes a single column where they report trading activity for a few strike prices for about 50 companies. Yet stock LEAPS are available for over 400 companies and at a great variety of strike prices.

LEAPS, Simply Defined

Stock LEAPS are long-term stock options. The term is an acronym for Long-term Equity AnticiPation Securities. They can be either a put or a call. LEAPS typically become available for trading in July, and at first, they have a 2.5-year lifespan.

As time passes, and there are only six months or so remaining on the LEAP term, the option is no longer called a LEAP, but merely an option. To make the distinction clear, the symbol of the LEAP is changed so that the first three letters are the same as the company’s other short-term options.

LEAPS Are Tax-Friendly

All LEAPS expire on the third Friday of January. This is a neat feature because if you sell a LEAP when it expires, and you have a profit, your tax is not due for another 15 months. You can avoid the tax altogether by exercising your option. For example, for a call option, you purchase the stock at the strike price of the option you own.

Owning Call LEAPS Is Much Like Owning Stock

Call LEAPS give you all the rights of stock ownership except voting on company issues and collecting dividends. Most importantly, they are a means to leverage your stock position without the hassles and interest expense of buying on margin. You will never get a margin call on your LEAP if the stock should fall precipitously. You can never lose more than the cost of the LEAP – even if the stock falls by a greater amount.

Of course, LEAPS are priced to reflect the inputted interest that you avoid, and the lower risk due to a limited downside possibility. Just like in everything else, there’s no free lunch.

All Options Decay, But All Decay is Not Equal

All LEAPS, like any option, go down in value over time (assuming the stock price remains unchanged). Since there are fewer months remaining until the expiration date, the option is worth less. The amount that it declines each month is called the decay.

An interesting feature of the monthly decay is that it is much smaller for a LEAP than it is for a short-term option. In fact, in the last month of an option’s existence, the decay is usually three times (or more) the monthly decay of a LEAP (at the same strike price). An at-the-money or out-of-the-money option will plunge to zero value in the expiration month, while the LEAP will hardly budge.

This phenomenon is the basis for many of the trading strategies offered at Terry’s Tips. Quite often, we own the slower-decaying LEAP, and sell the faster-decaying short-term option to someone else. While we lose money on our LEAP (assuming no change in the stock price), the guy who bought the short-term option loses much more. So we come out ahead. It may seem a little confusing at first, but it really is quite simple.

Buy LEAPS To Hold, Not To Trade

One unfortunate aspect of LEAPS is due to the fact that not many people know about them, or trade them. Consequently, trading volume is much lower than for short-term options. This means that most of the time, there is a big gap between the bid and asked price. (This is not true for QQQQ LEAPS, and is one of the reasons I particularly like to trade in the Nasdaq 100 tracing equity.)

The person on the other end of your trade is usually a professional market maker rather than an ordinary investor buying or selling the LEAP. These professionals are entitled to make a profit for their service of providing a liquid market for inactively traded financial instruments such as LEAPS. And they do. They manage to sell at the asked price most of the time, and to buy at the bid price. Of course, you are not getting the great prices the market maker enjoys.

So when you buy a LEAP, plan on holding it for a long time, probably until expiration. While you can always sell your LEAP at any time, it is expensive because of the big gap between the bid and asked price.

Back to TOP

TERRY’S TIPS STOCK OPTIONS TRADING BLOG

March 5, 2024

March 5, 2024

Sunny Outlook

We’re headed back to the bullish side this week with a trade on First Solar (FSLR). The country’s largest solar module maker reported earnings on Tuesday after the bell. Earnings per share came in above estimates, while revenue fell short despite growing more than 15% year over year. The company guided earnings and sales that were in line with or slightly higher than the analyst consensus.

The stock jumped as much as 9% on the news before closing 3% higher. That’s in sharp contrast to other solar companies, which have been plagued by lower demand, high interest rates, regulatory changes and higher inventories. But FSLR managed to overcome those headwinds with stronger pricing power, something analysts see continuing in 2024.

The news was not met with any ratings changes, though there were a few target price increases. Depending on the source, FSLR’s average target price is in the $210-235 range, which is well above Friday’s $158 close. Given that the stock reached a high of $232 last May – its highest level in the past 25 years – these estimates may be a tad overexuberant.

My take on FSLR – based on the charts – is more conservative. The stock has gone nowhere in the past five months, travelling mostly between the 140 and 175 levels. The 20-day and 50-day moving averages, which have provided nothing in terms of support or resistance, are horizontal and of little use.

Given the positive earnings results and outlook, we’re looking for the bottom of this trading range continuing to hold at 140, a level the stock has closed below just seven times going back to October 2022. The short strike of our put spread is at 140, which is more than 11% below Friday’s close. Because we’re going so far OTM with this trade, the credit and max return are somewhat lower than most of our trades. Less risk, less reward.        

If you agree that the stock will continue respecting the bottom of its trading range, consider the following credit spread trade that relies on FSLR staying above $140 (blue line) through expiration in 7 weeks:

Buy to Open the FSLR 19 Apr 135 put (FSLR240419P135)
Sell to Open the FSLR 19 Apr 140 put (FSLR240419P140) for a credit of $0.90 (selling a vertical)

This credit is $0.05 less than the mid-point price of the spread at Friday’s $158.05 close.   Unless FSLR surges at the open on Monday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $88.70. This trade reduces your buying power by $500, making your net investment $411.30 per spread ($500 – $88.70). If FSLR closes above $140 on Apr. 19, the options will expire worthless and your return on the spread would be 22% ($88.70/$411.30).

** We are crushing it! Our Costco (COST) portfolio is up 23% already this year. Our Microsoft (MSFT) portfolio is up 14% (last year this portfolio returned more than 70%). Don’t be left behind … there’s still time to save more than 50% on a monthly subscription to Terry’s Tips. Just Click Here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off.**

January 31, 2024

January 31, 2024

Dear [[firstname]],

Here’s your Option Trade of the Week as included in this past weekend’s Saturday Report for our Terry’s Tips Premium Members.The credit from last week’s trade ran away from us pretty quickly, so I opted to pass on sending it out knowing that you wouldn’t get the minimum credit. This week’s trade – which gets us back on a bullish track – has a better chance for entry. So, I’m hoping that you can make it work.

Before that, though, I have to tell you that our Microsoft (MSFT) portfolio – we call it Wiley Wolfis on fire. With January in the books, we are already up more than 22% while the stock itself is up less than 6%. In fact, we booked more than half that huge gain just today after MSFT’s earnings!

How did we do it? The same way we bagged 70% and 92% profits using MSFT and QQQ last year – Dr. Terry Allen’s 10K Strategy. This market-beating strategy has proven itself over the past two decades … and this year looks to be no exception.

You can’t afford to miss out on these profits. Resolve to make 2024 your best trading year ever – and learn about Terry’s unique strategy – by becoming a Premium Member of Terry’s Tips.

For our loyal newsletter subscribers (that’s you), I’m of course keeping the sale going that saves you more than 50% on a monthly subscription to Terry’s Tips. Plus, I’m adding a promise that this rate will never increase. I won’t make this promise forever, though, so now is the time to get in on the action … and profits.

As a Premium Member to Terry’s Tips, you’ll get …

  • A month of all trade alerts in our four portfolios, giving detailed instructions for entering and exiting positions. Trade one portfolio (I recommend Wiley Wolf) or all four. It’s up to you.
  • Four to five (depending on the month) weekly issues of our Saturday Report, which shows all the trades and positions for our four portfolios, a discussion of the week’s trading activity and early access to our Option Trade of the Week.
  • Instructions on how to execute the 10K Strategy on your own.
  • Access to our autobrokers to make trades on your behalf.
  • A 14-day options tutorial on the opportunities and risks of trading options.
  • Our updated 10K Strategy white paper, a thorough discussion of the strategy basics and tactics.
  • Full-member access to all our premium special reports that can make you a wiser and more profitable options trader. 
  • Annual subscription available for more than 50% savings

And, for a limited time, I am including a Special Bonus. Terry Allen has condensed his 30 years of options trading experience into an eBook – Making 36% – A Duffer’s Guide to Breaking Par in the Market Every Year, in Good Years and Bad. Learn a different way to trade using Terry’s unique and decades-tested 10K Strategy. This book is normally $9.98 on our website (and $19.95 on Amazon), but I will personally send you the digital version for free with a paid subscription.

To become a Terry’s Tips Premium Member, just Click Here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off. You can cancel after a month but, of course, keep all the valuable reports and the book.

I look forward to having you join in the fun and profits! Now on to the trade …

It’s Intuitive

Lots to chew on this week with earnings season in full swing, so let’s dive right in with a bullish trade on Intuitive Surgical (ISRG). The company makes surgical instruments, notably the da Vinci robot, that emphasize minimal invasiveness. ISRG reported Tuesday after the bell, easily beating on the top (profit) and bottom (revenue) lines. Earnings per share increased 30% from a year earlier, while revenues improved more than 16%. Much of this growth came from a 21% increase in da Vinci procedures.

Analysts were quick to raise their target prices, with at least a half dozen trying to beat each other to the punch. These were not minor increases, either. One firm raised its target by 35%, while several others were around 15%. That equates to increases of $30 to more than $100 … not bad for a $375 stock. Oddly, there were no rating increases, keeping ISRG at a solid buy rating. However, there are few holds on the stock, leaving some room for upgrades.

Also odd is the fact that the stock fell as much as 3.4% on Wednesday, though it closed just 0.4% lower. That’s the smallest move after earnings in more than 11 years. There wasn’t much action after that, as ISRG gained about a percent on Thursday and Friday. The stock reaction might give one pause given the strong earnings results. However, the muted move makes more sense since the company already released bullish guidance numbers a couple of weeks ago. That caused the shares to pop more than 10%, making this week’s news less impactful.

The guidance surge pulled the stock away from its 20-day moving average, a trendline that has guided a 47% rally over the past three months. The shares spent a few days just below the 20-day in early January, the only time they were staring up at the trendline since crossing above it on November 1. We are therefore using the 20-day as the basis of this week’s bullish trade. The short put strike of our spread sits just below the 20-day, which is about 6% beneath Friday’s close.

If you agree that the stock will continue trading above, or at least near, the 20-day moving average (blue line), consider the following credit spread trade that relies on ISRG staying above $350 (red line) through expiration in 7 weeks:

Buy to Open the ISRG 15 Mar 345 put (ISRG240315P345)
Sell to Open the ISRG 15 Mar 350 put (ISRG240315P350) for a credit of $1.00 (selling a vertical)

This credit is $0.10 less than the mid-point price of the spread at Friday’s $374.76 close.   Unless ISRG surges sharply at the open on Monday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $98.70. This trade reduces your buying power by $500, making your net investment $401.30 per spread ($500 – $98.70). If ISRG closes above $350 on Mar 15, the options will expire worthless and your return on the spread would be 25% ($98.70/$401.30).

Testimonial

It is often said that options are to stock trading as chess is to checkers. I was looking to find the chess master amongst the checker’s champs, and Terry is the one. Looking for very smart yet understandable way to trade options? Look no further. ~ Phil Wells

Remember to click here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off. And get Terry’s eBook for free.

Any questions?  Email Jon@terrystips.com. Thank you again for being a part of the
Terry’s Tips newsletter.

January 17, 2024

January 17, 2024

Dear [[firstname]],

It may be a little late, but Happy New Year! I haven’t sent an issue for a while because the credits for our weekly trades weren’t close enough to my target entry prices. As you know, I will not send an issue with a trade you have no chance of entering. This week, however, the credit is higher than when I sent the trade to our premium subscribers, meaning your maximum profit is now greater.

This is my first chance to tell you about the amazing profits we racked up last year. Our QQQ portfolio gained more than 90% for the year, while our MSFT portfolio brought in 70%. We’re on some kind of roll with MSFT, averaging gains of more than 100% over the past 5 years. And 2024 has started the same way … in the profit column.

You can’t afford to miss out on these profits. Resolve to make 2024 your best trading year ever with a subscription to Terry’s Tips.

For our loyal newsletter subscribers (that’s you), I’m of course keeping the sale going that saves you more than 50% on a monthly subscription to Terry’s Tips. Plus, I’m adding a promise that this rate will never increase. I won’t make this promise forever, though, so now is the time to get in on the action … and profits.

As a Premium Member to Terry’s Tips, you’ll get …

  • A month of all trade alerts in our four portfolios, giving detailed instructions for entering and exiting positions. Trade one portfolio or all four. It’s up to you.
  • Four to five (depending on the month) weekly issues of our Saturday Report, which shows all the trades and positions for our four portfolios, a discussion of the week’s trading activity and early access to our Option Trade of the Week.
  • Instructions on how to execute the 10K Strategy on your own.
  • A 14-day options tutorial on the opportunities and risks of trading options.
  • Our updated 10K Strategy white paper, a thorough discussion of the strategy basics and tactics.
  • Full-member access to all our premium special reports that can make you a wiser and more profitable options trader. 

And for a limited time, I am including a Special Bonus. Terry Allen has condensed his 30 years of options trading experience into an eBook – Making 36% – A Duffer’s Guide to Breaking Par in the Market Every Year, in Good Years and Bad.” Learn a different way to trade using Terry’s unique and decades-tested 10K Strategy. This book is normally $9.98 on our website (and $19.95 on Amazon), but I will personally send you the digital version for free with a paid subscription.  

To become a Terry’s Tips Premium Member, just Click Here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off. You can cancel after a month but, of course, keep all the valuable reports and the book.

I look forward to having you join in the fun and profits! Now on to the trade …

United We Fall

Earnings season started this week, though the number of reports was limited. Big banks dominated the headlines, but I didn’t see anything tradeable there. And I was looking for a bearish play to diversify a portfolio that will be all put spreads after this coming Friday.

So, I went with a company that’s bigger – by market cap – than any bank: UnitedHealth Group (UNH). The company reported on Friday, beating expectations for both revenue and income. But a key metric – the medical cost ratio – came in well above estimates. And that proved to be UNH’s undoing, as the stock slumped 3.4% on Friday.

UNH has a half-trillion-dollar market cap, so it gets a lot of analyst coverage. But oddly, there wasn’t a peep from the analyst community on Friday –  no ratings changes and no target price moves. Perhaps they were mulling over their overly bullish stance toward the stock.

According to Yahoo! Finance, all 22 rating analysts consider UNH a buy or strong buy. The average target price is around $600, which is 15% above Friday’s close and 7% above the stock’s all-time high, set in October 2022. And it’s not like UNH set the world on fire in 2023. In fact, the stock closed the year a few bucks lower. Maybe we’ll start seeing some analysts ease back on the throttle and temper their targets and ratings, which could put some pressure on the stock.

The price drop on Friday pulled the shares below both their 20-day and 50-day moving averages. For the technical purists, the 20-day (blue line) bearishly crossed below the 50-day (red line) at the end of last year.

I’ve also noted an interesting pattern with UNH. Whatever the stock does the day after earnings tends to be the path for the next several weeks. After the past two earnings reports, the stock gained after earnings and continued to be higher through the subsequent five weeks. The two quarters before that, it was the opposite story – lower the day after earnings and five weeks after earnings. So, if history holds, UNH may find some rough sledding for the next few weeks. Plus, it will have to overcome its short-term moving averages, which are both headed lower.

This week’s bearish call spread has a short strike at the 540 level, which is above both the 20-day and 50-day moving averages. It also sits in an area where the stock has struggled to consistently stay above. Note that this is a 10-point spread because that is the strike increment in the 16Feb series. We’re going with the monthly series because UNH’s weekly options have poorer liquidity. Thus, these spreads will require more buying power, as noted below.

If you agree that the stock will continue to struggle after its earnings slump, consider the following credit spread trade that relies on UNH staying below $540 (green line) through expiration in 5 weeks:

Buy to Open the UNH 16 Feb 550 call (UNH240216C550)
Sell to Open the UNH 16 Feb 540 call (UNH240216C540)

for a credit of $2.20 (selling a vertical)

This credit is $0.10 less than the mid-point price of the spread at Friday’s $521.51 close.   Unless UNH falls sharply at the open on Tuesday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $218.70. This trade reduces your buying power by $1,000, making your net investment $781.30 per spread ($1,000 – $218.70). If UNH closes below $540 on Feb 16, the options will expire worthless and your return on the spread would be 8% ($218.70/$781.30).

Testimonial of the Week

I have been a subscriber for about a year. I autotrade in 2 different accounts, all your strategies. I read everything you write on Saturdays. I love your happiness thoughts and everything else. I usually do not communicate at all but I had to tell you how well my accounts with you are doing compared to everything else. You are awesome. Keep up the good work. Thank you. – Maya

Remember to click here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off. And get Terry’s eBook for free.

Any questions?  Email Jon@terrystips.com. Thank you again for being a part of the Terry’s Tips newsletter.

Happy trading,

Jon L

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