Ladies and gentlemen, welcome to the road to degeneracy. Without having to reinvent the wheel, and then writing a book about reinventing the wheel, i'll just sprinkle some starter yeast and, like a beautiful acid trip, we'll see where it takes us....
Why options trading
- Leverage. You can control a lot more stock for $.
- Flexibility. You can play any sentiment - bullish, bearish, neutral - and you can pick and choose the risk-reward! Instead of just choosing a safe vs risky stock, for any given stock, you can choose how much you want to lever its movement.
- Engagement. Options have an element of time expiration in their construction, which obliges you to stay in (somewhat) active and engaged in the market.
What are options
- These are contracts that grants the contract holder the right (but not the obligation) to buy or sell 100 units of stock at an agreed price, before a certain date.
- It has these elements: Strike price, Expiration date
- Call option - contract holder can buy ABC stock from contract seller. option buyer "calls" the shares away from sellers' account
- Put option - contract holder can sell ABC stock to contract seller. option buyer "puts" the shares in sellers' account.
- Options are tradeable instruments like units of stocks. For our practical purposes, we don't really worry about the above (yet). We buy when cheap and sell when high. Or sell when high and buy when cheap.
How do you price options? (i.e. what is cheap?)
If you're a nerd, you'd invoke the Black-Scholes equation. If, like me, you failed 9th grade trig, you can think of it in more simple abstract terms:
- options premium = Intrinsic Value + Extrinsic Value = (Strike$-Stock$)+(Volatility*Time)
Take Apple, which is 135$ right now. How much would you pay to have the right to purchase shares of Apple for $130/share at anytime....
before the end of the week?
- At least $5/share, because this agreement already has $5 of intrinsic value (135-130), and youre paying for the chance Apple might run up higher. This contract is at 5.25 right now
before the end of the month?
- More than the above, because there is more time value (the extrinsic) in the contract. This contract is at 7.45 right now.
How do I profit from this information?
- The cro-magnum approach is if you think AAPL goes up, you buy the call options for leverage, and if it does go up, you can sell it for higher profit % than trading the shares, using same cash. (sometimes). It requires the right conditions to be profitable. I trade this way this sometimes.
- The real approach is to exploit changes in extrinsic value, buying when low, and selling when high. This is based on the fact that expected future volatility is almost always higher than actual realized volatility, meaning options often cost more than they're mathematically worth. So I sell an option, then later buy it back when it becomes cheaper or worthless. I trade this way all of the time. Think of it as selling overpriced insurance.
- As stated above there is a million ways to trade options, which is the beauty of it, but overwhelmingly i sell overpriced options, and sometimes pounce on buying underpriced options.
Where do I trade options?
Basically any broker will allow it. But you first have to request permission to trade options. They're typically bracketed into different levels of approvals which grants you more exotic strategies and ways to bankrupt yourself. All it takes is a quick questionnaire where you lie and tell them you have an undergrad from Booth and an MBA from Wharton.
For my money Tastyworks is a very clean options-centric platform for active trading, but all the other guys should be good as well.