There are 3 directions the price can move in. This article looks at an upwards move.
Every position that is entered is based on expectations of where the price will be at some point in the future. This future could be mere minutes away for a day trader all the way up to many months away for a very long term investor. The time frame of the trade will be covered in a future article. Today I want to explore some of the risks and rewards that are associated with different types of trade.
From today there are 3 things the price could do. It could move up #1, it could just move sideways #2, or it could fall #3. As long as the stock continues to trade, it will move in one of those 3 directions! This is something that recurs each and every day. From where ever the price is currently at, you can draw these 3 lines on the chart and say it will do one of the 3.
Whether you use fundamental analysis, technical analysis, or just flip a coin, when you enter a position you are entering one expecting the price to move in one of these 3 directions.
For scenario #1 we would be expecting the price to move up. To take advantage of this move we could buy stock. The advantage of this is you don’t have to worry about time and can take advantage of the entire move, especially if it becomes a very strong move. The disadvantage is that you tie up a lot of capital to enter the position, and you have the risk of a move against you, or a sideways move that leaves you with “dead” money where it is not making or losing anything. The bad thing about dead money though, is that it would be earning interest if just left in an interest bearing account, and it is pretty bad when a bank account out performs a trading account.
Another way we could take advantage of this move would be to buy calls. There are 2 main advantages of buying calls, the first is that it takes less capital, and the second is that the % of gains can be much greater than what you get from buying stock. Example, if you buy 100 shares of qqq at 37 and it moves to 39 you gain 2 points, or 5%. If you buy a 37 call at $0.50 and the price goes to 39, you can sell that call for at least $2.00, maybe more depending on time. This is at least a 300% profit. So instead of using $3,700 to make $200 profit you can use $50 to make $150 profit. This leverage is a key advantage of using options. The second advantage is that when you buy a call your risk is limited to the amount paid for the call. If you spend $3,700 to buy 100 shares of the stock, and the price falls to $35, you have lost $200. If you spend $50 to buy that one contract of 37 calls and the price falls to 35, you have lost $50. If the price falls to 30 you would lose $700 in the stocks value, but the calls remain at a $50 loss, the amount you paid for them.
Buying calls gets to be a bit more complicated because there are so many “options” to choose from. The first issue with buying calls is what strike to buy. Will you buy ITM (In The Money) where it will have a higher delta? By doing this the option gains more as the price moves up. An ATM (At the money) or OTM (Out of the Money) strike will have a lower delta, and will result in less of a gain until they become ITM. But the ATM and OTM calls are cheaper to enter. The second issue is what expiration month to use. When you buy calls you not only have direction to worry about, there is also the matter that the move MUST take place before the calls expire. This leads to the reason that so many people lose money with options. They wind up buying lottery tickets because they are so cheap, not realizing that the very short time left until expiration does not give the stock a chance to make the needed move to bring the price up to the Out of The Money strike price that they bought. So their lottery ticket expires worthless!
There is also another way to use options to help control risk. If you buy stock you can purchase “insurance” on that position.
This is simply done by buying 1 put for every 100 shares of stock. Example, if you bought the q’s at 37, you spend $3700 to enter that position. Lets then assume you are planning on holding this position for more than just a few days, so you will want some options that will give you time to let this position play out. You then determine how much of a move you are willing to accept as your risk. For sake of this argument let us use 1 point. You would then look at the next expiration month, and you could buy the 36 puts for $0.75, or $75 per contract. Your overall cost of the position is now $3,775. Should the price move up like expected, then that is fine, this expense for insurance is just like the expense you make on your house and car where you pay for the protection but don’t use it. But if the price moves against you, and falls below 36, then the puts will “kick in” like an insurance policy and stop your loss in the $100 area. The important thing to remember here, is that this insurance is for a limited amount of time, and because of this, the time frame of the trade will have to be taken into consideration.
Lastly, there is one other way calls can be used to take advantage of the expected move up. That is with spreads. There are 2 main types of spreads, the simple vertical spread such as if you were to buy the 37 call and sell the 38 or 39 call. The advantage with this is that your cost to enter the position is decreased, but you reward is also limited to the strike that you sell. The other main spread that can be used is a calendar spread, where you buy the 37 call in a future month, and would sell the current month 38 or 39 strike. This is a longer term type of position, where you are buying a call that you want to gain value over the course of time, and you sell the near month calls to collect premium to pay for that call that you bought. This is a more challenging position to maintain, as timing of when to enter and adjust it becomes very important.