There’s a lot more to consider when trading options as opposed to the actual underlying stock.
For a stock like Bank of America (BAC), if you think that shit is going up then buy however many shares you want, set a simple stop area (the point at which you’ll sell and take your loss if you were wrong), and then just ‘lean wit it rock with it’.
To play the same move in an option, you have to assess what the stock will do in a given time period and then select which option you feel will gain the most in value.
This is no easy task folks.
But not to worry you newbie options traders!
To understand options all it takes is repetition. If you see a big move in a stock you have been watching, just pull up an options chain and look at the action in the Calls or Puts both in and out the money. (In and out the money is a concept I went into on previous parts.) After you do this over and over you’ll understand which options to go for instinctively.
If you missed Parts 1 – 4 and are still uneasy with options basics, I suggest you back-track and check those out before delving into this new material.
We will continue to use Bank of America (BAC) as an example for this series.
Clearly, this stock has had quite a big run-up. For today’s lesson, we’re going to assume you guys want to play a possible pullback on this stock by buying some Put options.
Which option do you buy? What strike? What month do you buy?
This is a partial option chain for the January Puts in BAC…
There’s a simple process that one should go through whenever trying to select which option to play. General questions should be asked such as, “how many days do I have left until expiration, what’s the likelihood of this move happening within that time period, how expensive are the options and what’s the open interest and volume looking like?”
Let’s throw an example out to give you guys some more insight…
You think the stock is due for a MAJOR pullback and the bulk of the move could happen in one or two days. $14.50 you have in your head as the area where he can get to. First thing you need to consider is how many days you have left until expiration. January expiration is on Friday the 21st that gives you 4 days until expiration. 4 days is not a long time in the options world. Out of the money options, in this case $15 or $14, drop in value VERY quickly if the stock isn’t heading in that direction ASAP before expiration. This is something you MUST keep in your head at all times if you decide to play the out of the money option here.
So now let’s say you theorize that buying the out of the money puts for January are too risky. You decide to play IN the money instead so you’re thinking about the $16 Put. The $16 Put costs $.87. The stock itself closed at $15.25 which means there is about a $.12 premium in the option ($16 – $.87 = $15.13 If you don’t understand this go back in the previous posts). Now if the stock does actually go down below $15 this option will start getting a lot of action BUT, percentage wise, you ain’t gonna knock it out of the park with this because the option is already so expensive (in the money). For example, if the stock gets to $14.80, by expiration your option will be worth $1.20. You made a little less than 50% on your money.
How do I know when the stock will pullback??
LOL, well that’s the trick of the game folks. If you knew that shit then I wouldn’t be sitting here writing this post because yo’ ass wouldn’t need me. This is where ‘tape reading’ comes into play for me. Tape reading allows me to make a good prediction on what will happen in the short-term future of my stock, more so than just a shot in the dark. Tape reading is a subject I will delve into through video lessons at a later time so for now, you’re going to have to stick to your own instincts!
Let’s go back to our example…
Most of the time, buying out of the money options will pay you out GINORMOUSLY if you are correct in the move. If you’re not, you lose just as big. Many times it is not safe to buy these options unless you truly understand the risks. You must be able to watch constantly and take your losses VERY quickly if you feel you are wrong in the move. Therefore, you can save yourself a really bad day by cutting the trade short right away. Many people get crushed with this particular strategy because they have blind faith in the stock doing xyz. What they don’t take into consideration is HOW LONG it will take their stock to do that. If you’re unsure of time periods, buying a month out may work well for you. That will allow you to buy something out of the money and get the percentage gain without having to worry TOO much about losing premium in your stock. Of course, you’ll still have to worry BUT it won’t be as wild!
Stay tuned as we continue this series further!
Stick with Lucci!