Selling Options is Smarter
Selling options is smarter than buying, and it is more complicated than trading stocks. And when you trade it for the first time it can be a little intimidating.
That’s why many investors decide to begin trading options by buying short-term calls. Especially out-of-the-money calls (strike price above the stock price). The buyer is hoping to buy it for a Low price and to sell it for higher price later on.
But buying out-of-the-money short-term calls is not the best way to start trading options. In the next example we tell you why.
You have the assumption that stock XYZ will rise. It is trading now at $50. As a newby options trader, you are tempted to buy calls for $15 per contract. You think it will happen within a month time. Why would she do this transaction? Because you can buy a lot of them. How well will this work out. Let’s do the math.
When you buy a call option with a strike price of $55 at a cost of $0.15, and the stock currently trading at $50, you need the stock price to rise $5.15 before your options expire in order to break even. That’s a pretty significant rise in a short time. And that kind of move is very difficult to predict.
Purchasing 100 shares of XYZ at $50 would cost $5000. But for the same $5000, you could buy 333 contracts of $55 calls, and control 33,300 shares. Holy smokes.
Imagine XYZ hits $56 within the next 30 days, and the $55 call trades at $1.05 just prior to expiration. You’d make $29,970 in a month. At first glance, that kind of leverage is very attractive indeed.
All that glitters is not a Golden Options Trade
One of the problems with short-term, out-of-the-money calls is that you not only have to be right about the direction the stock moves, but you also have to be right about the timing. That ratchets up the degree of difficulty.
Furthermore, to make a profit, the stock doesn’t merely need to go past the strike price within a predetermined period of time. It needs to go past the strike price plus the cost of the option. In the case of the $55 call on stock XYZ, you’d need the stock to reach $55.15 within 30 days just to break even. And that doesn’t even factor in commissions or taxes.
In essence, you’re asking the stock to move more than 10% in less than a month. How many stocks are likely to do that? The answer you’re looking for is, “Not many.” In all probability, the stock won’t reach the strike price, and the options will expire worthless. So in order to make money on an out-of-the-money call, you either need to outwit the market, or get plain lucky.
Being close means no glory
Imagine the stock rose to $54 during the 30 days of your option’s lifetime. You were right about the direction the stock moved. But since you were wrong about how far it would go within a specific time frame, you’d lose your entire investment.
If you’d simply bought 100 shares of XYZ at $50, you’d be up $400. Even if your forecast was wrong and XYZ went down in price, it would most likely still be worth a significant portion of your initial investment. So the moral of the story is:
Don’t get suckered in by the leverage you get from buying boatloads of short-term, out-of-the-money calls.
Selling options is smarter
Selling Options provides you the ability to generate income on your portfolio. If the option you have sold expires without exercise,you keep the entire premium. Another key benefit is the ability to own the underlying stock for a price below the current market price. If you got assigned and the stock price is above your break even you still make money. When it is below your break even you may sell an ATM call and receive another credit. Let me give you some examples:
When the stock goes down to $49 dollar at expiration. You bow have to buy 100 share for $49. Since you have received $2.50 premium your break even is $47.50. You still have $150 Profit!
The next thing you can do is either selling the shares for $49 or selling a call option $49 for $1.25. Your new break even will be $47.75. When the stock price rise above $50. Then your profit is $3.
When you buy an option you have to be right about the direction and it has to move fast enough to be above your break even price at or before expiration.
With selling options you receive a credit when you enter the trade. You may keep it when the stock stays flat, goes up or even a little bit goes down.