Option trading provides you with the ability to leverage stock returns in your portfolio like no other tool in the stock market. Many investors spend their entire investing lives without truly understanding what options are and the opportunities they missed out on. As a traditional buy and hold investor, I was content with modest returns in my portfolio. Growing up, I often heard comments about the importance of investing in S&P 500, an index composed of the 500 largest companies in the US. If you did invest your market returns would average around 8%-10% annually over the long-term. It seemed reasonable to be satisfied with similar annual returns as an individual stock picker.
While a simple buy and hold strategy of the S&P 500 index is suitable for most people, I have always been a hands-on investor. Instead of the traditional approach of investing in a 401k and aiming to become a millionaire by 65, my goals were always to achieve more. I wish I had known more about low-risk, high-reward option strategies such as buying long calls, puts, selling cash-secured puts, and selling covered calls, which can significantly boost market returns when executed correctly.
So, why should one trade options?
For a while, I felt quite pleased with myself as a few of my individual stock positions gained 25-30% over a two-year period, seemingly beating the market. I believed that consistent investing of at least 10% of my paycheck each month would bring me closer to my financial goals. However, it was during the pandemic, when I witnessed market crashes and the rapid erosion of market returns, that I was introduced to options and the first strategy I learned of is hedging, which is essential in option trading.
As I watched all my positions lose their gains, I felt a sense of helplessness. It seemed like my only options were to either panic sell all my positions or hold onto them, hoping for a rebound which could’ve taken weeks or even years. However, as I learned more about options, I discovered a third alternative.
Protective Put:
Selling stocks in which you still have faith, particularly if the company’s fundamentals remain strong, is never ideal. Hedging, a commonly used option strategy, protects against losses when a company’s stock price is falling. By purchasing a protective put option, you can safeguard yourself from further losses. For instance, if your cost basis on a stock is $45 per share, you can buy a put option at the $40 strike price, with a future expiration date of 3 months to a year. This way, if the stock price falls below $40 at any point during that period, the increasing value of the put option would offset the declining value of your stock.
Getting started with option trading:
If you’re considering venturing into option trading, I encourage you not to make options your primary focus right away. First, determine the type of investor you are or want to be. Are you a value investor who prefers holding blue-chip names like Coca-Cola and Apple? Or are you a growth investor with a higher risk tolerance, looking for companies like Nvidia, AMD, and Tesla? The reason I stress this point first is because the positions you buy, hold, and trade will form the foundation of everything you do with options.
The Wheel strategy:
One of the most popular option trading strategies is the Wheel strategy. The first part of this strategy involves a put writing strategy known as a cash-secured put. To begin, you need to choose a stock you want to buy and determine a price at which you would be comfortable owning it. Then, you sell a put option on that stock at a specific strike price, which means you have the obligation to buy 100 shares of the stock if it reaches that strike price before a predetermined expiration date.
For example, let’s consider Tesla stock, which is currently trading at around $164 per share. If you believe this price is too high, you could decide to sell a put option with a strike price of $150, expiring three months from now (the week of July 21st, 2023). This put option would pay you a premium of about 5% or $890.
If you have a bullish long-term outlook on Tesla but don’t want to pay too much for owning it, you wouldn’t be disappointed if the stock price dropped to $150. If Tesla doesn’t drop to $150 per share by July 21st, you keep the premium without any obligations, and you can open another position to collect more premium. You can repeat this process over and over. The only requirement for this strategy is having the collateral ($15,000) to take ownership of the shares. Since stocks don’t only go up, eventually you may be assigned the shares.
On the other side of the strategy, there is a potential downside. For instance, if the stock price falls to $125 per share, as the option seller, you are still obligated to buy the stock at $150 per share. This would result in starting your position in Tesla down by $25 per share or 15%. However, there is some good news. Remember the $890 you received initially? Well, that premium factors into your cost basis. So even though your position is down, your cost basis is technically around $141 per share instead of $150 per share, meaning you are down by approximately 11%.
Another positive aspect is the ownership of the shares. If you have strong conviction in the long-term outlook of Tesla or any other company you like, you would be pleased to own the stock at a discounted price. Once you own some shares, you can move on to the second part of the Wheel strategy: covered calls.
Covered calls:
Now that you own 100 shares of Tesla, you can write a covered call. In this strategy, you essentially put your shares up for sale by selling a call option at a predetermined strike price. By doing this, you have the obligation to sell those shares if the stock reaches that strike price, and in return, you receive a premium. Let’s continue using Tesla as an example.
Assuming Tesla shares are currently trading at $164 per share, instead of merely holding the shares and waiting for them to appreciate over time, you can sell a $185 call option expiring on July 21st. By doing so, you collect a premium of approximately $735, which translates to roughly a 4% return over two months. Essentially, if Tesla reaches $185 per share by July 21st, you will have to sell your shares at that price, regardless of how high the stock price goes.
At first glance, it may seem like a favorable outcome. You gained $21 per share in share price appreciation, along with the collected premium, resulting in approximately $2,835 in profit from your Tesla shares.
Making a profit is always a positive outcome, but you may later realize the missed potential. For instance, let’s say shortly after this trade concludes, Tesla’s stock price rises to $200 per share or even higher. This means you would have missed out on the additional upside potential of the stock.
This is where your outlook for the company becomes crucial. If you believe the stock still has more room to grow, you can choose to buy back the call option and accept a loss on the position. Keep in mind that buying back the call option would likely be more expensive than the $735 premium you received, depending on how much the share price increased.
Alternatively, you can be less aggressive in choosing the strike price of the calls you write by opting for higher strike prices, such as $190 or $195. This reduces the likelihood of the stock reaching that strike price but also lowers the premium you would receive. People are often enticed by writing aggressive calls to generate higher premiums on their stocks.
Investing in any asset always involves a risk-reward factor, and we take on risks in hopes of better returns. The objective is for those returns to surpass what we could achieve by investing in savings accounts or bonds. This mindset guides me when weighing the pros and cons of any option strategy I utilize.
It’s easy to get caught up in the excitement of turning $1000 into $10,000, and many individuals who engage in option trading have experienced the thrill of chasing those returns. However, after learning some lessons the hard way, they typically abandon strategies that fell more like gambling and instead seek more stable and risk-defined strategies, such as the ones we discussed.
These strategies are just one of several utilized by prominent hedge funds in the public markets. I used all the resources available to me to reach a point where I felt less overwhelmed and confused when considering how to implement these strategies, trial and error was the best teacher for me personally. Check out the Chicago Board Options Exchange to learn more about option trading, jumping right in usually results in financial loss. Your brokerage account might also have some great resources you can utilize as well.