The Power Of Options
(The Easiest Guide You’ll Ever Find)
Grab a coffee, sit down somewhere nice and quiet, and prepare to be amazed at the power of options…
Read the guide below, then to cement your understanding (it’s easy, really) watch the 20min video at the end of the page which gives examples of how we use them every day to profit.
Trading stocks directly means you need a lot of capital to make meaningful gains. Most people starting out in trading do not have anywhere near enough capital, nor do they wish to risk so much on a new initiative they are beginning to learn.
So, what are options and how can they help us make more money using less capital, and reduce our risk?
Let’s dive straight in…
- A CALL option gives you the right (with no obligation) to BUY a particular stock at a predetermined price – known as the strike price.
- A PUT option gives you the right (with no obligation) to SELL a particular stock at a predetermined price – known as the strike price.
The rights the options give you can be exercised anytime up until the option expires. (The 3rd Friday of each calendar month is known as options expiry for that calendar month, e.g. AAPL January 2017, will expire on the 3rd Friday in January 2017.)
However, at Trading with Zach, we never actually exercise the options we buy.
In fact 70% of all options traded are never exercised – you’ll understand why in a moment.
We simply buy options on an underlying stock, and when that stock hits our target price, we simply sell those options which are now worth substantially more, and hence make a profit – and a substantially bigger profit than if we bought the underlying stock itself.
So, in the case of Call options, they go up in value as the underlying stock rises, only significantly more.
Again – we never actually exercise the right the options give us. We simply use options as our trading vehicle because of the explosive gains they can make.
- Remember: for CALL options we want the underlying stock to go up. For PUT options, we want the underlying stock to go down.
The intrinsic value of an option is the difference between the strike price and the actual current value of the underlying stock (For now, assume the underlying stock price is ABOVE the strike price). We’ll refer to this as ‘the value of an option’. (There is also something called the ‘time value’ of an option which increases the value of an option, but let’s leave that to one side for now).
Example of a Call Option
Where the stock current value is ABOVE the strike price:
The intrinsic value of the option = Actual Current Price of Stock MINUS the Strike Price.
e.g. If Apple Inc. (AAPL) is currently $100, then we can calculate what the value of the option is at a given strike price… So,
The AAPL $60 strike option will be valued at $40. ($100 – $60)
The AAPL $70 strike option will be valued at $30. ($100 – $70)
The AAPL $80 strike option will be valued at $20. ($100 – $80)
In the examples above, the CALL options are known as being ‘In The Money’ because the actual underlying AAPL price is higher than the strike price. i.e. they have intrinsic value.
- Remember: The strike price is the price at which we have the right to buy AAPL at, should we exercise the options. Remember though, in practice we’re not intending to exercise those options – we just want to sell them later and close our trade for a good profit.
How to calculate how much an option will be worth when the underlying stock reaches our target
Now, let’s say we know from looking at a chart of AAPL, that AAPL, currently at $100 is going to rise in the coming weeks to a price of $120 – a rise of 20%…
Based on what we’ve said above, we can very easily re-calculate what those options will be worth if AAPL gets to $120…
AAPL now at $120, so…
The AAPL $60 strike will be worth $60. ($120 – $60)
The AAPL $70 strike will be worth $50. ($120 – $70)
The AAPL $80 strike will be worth $40. ($120 – $80)
Did you notice something? AAPL rose in value by 20%, but our options went up…
The AAPL $60 strike went up by 50%!
The AAPL $70 strike went up by 67%!
The AAPL $80 strike went up by 100%!
WOW!… the power of options!
In all the examples above, the strike price (where we have the right to buy AAPL) was lower than the actual current price of the underlying AAPL stock price. i.e. Those options were therefore worth something (intrinsic value) because they give you the right to buy AAPL at a lower price than where AAPL currently is. And there is of course value in doing such a thing, because you could exercise those options and buy AAPL at that cheaper price (the strike), then sell AAPL straight away at the current value and make a profit. i.e. those options have intrinsic value! The point is here is that options that are ‘in the money’ i.e. strike price is lower than the actual current price will have value in them.
Ok… the flip side, and this is where the risk factor comes in.
Q. AAPL is currently $100. Would you want to buy the AAPL $110 strike call options? i.e. would anyone be interested in having the right to buy AAPL at $110, when AAPL is currently $100, and even pay for that right?
In this case, the options are known as being ‘Out of the money’. i.e. they have NO intrinsic value because the rights they give you are essentially worthless – i.e. no one wants the right to buy AAPL at $110, when the current price is $100.
They do however have some value, something that is called Time Value, i.e. even though the intrinsic value is currently zero, there is a chance the underlying stock may rise above the strike price by the time the option expires. An option with a longer time to expiry will therefore have more time value than an option which expires sooner.
Options that are out of the money (the actual current price of the underlying stock is less than the strike price) will therefore decay in value all the way to zero if the underlying stock remains below the strike price – i.e. the options you bought will decay in value and you will lose 100% of what you invested by the time the option expires! – Yikes!
So, who would want to buy an option with a strike price higher than the current price of the underlying stock?
Well… Consider this…
AAPL is $100 today. The $110 strike Call options (expiring say, 3 months from now) is only $2 – (it has little value of course, because its rights are worthless at present as explained above).
What if AAPL rises to $120, as in our earlier example – what would the $110 strike Call option then be worth?
Well, let’s apply the formula we used before:
The value of option = Actual Current Price of Stock ($120) MINUS the Strike Price ($110) = $10.
Did you notice that? – Our options are worth $10… and what did we pay for them? $2!
WOW WOW WOW!!! – Our options went up by 5x – that’s a profit of 400%!
And how much did AAPL go up by? – just 20%!
Without wanting to make this options guide too long, you should be aware of some other points.
As mentioned, Options with a longer time until expiry will have more time value than options that are expiring imminently, and especially so where the options are ‘out of the money’, as there is no intrinsic value whatsoever, the only value in the option being time value.
Let’s take our AAPL example once again.
AAPL is $100 today. The $110 strike Call options (this time, expiring say 1 month from now) is only $0.45. (It’s much cheaper than before because the options expire in 1 month’s time, and so the rights are have less time in which they can be exercised – hence they are cheaper.)
So if AAPL gets to $120, our options will be worth $10, exactly as before, only this time we bought the options for $0.45!! – that would be a gain of 22x or just over 2000% profit – TWO THOUSAND PER CENT!
Put options work in exactly the same way, but the opposite of Call options. i.e A stock where the current price is lower than the put option strike price is ‘in the money’ and will have intrinsic value. (Remember a Put option gives us the right to sell a stock at the strike price). A stock where the current value is higher than the strike price is out of the money, and practically worthless.
In all our calculations above, we’ve actually determined the minimum value of an option. In practice, options will have slightly higher values, as there is something called ‘time value’ and ‘implied volatility’. That’s beyond the scope of this guide, but it allows you to pocket even bigger gains!
So, to sum up, options can give us really spectacular gains even where the underlying stock makes a modest move. However, if the underlying stock goes against us, then our options will go down in value and one can potentially lose all we invested in that trade.
But, that is the beauty of options. Your risk is always defined and fixed. Whenever you enter an options position, you are always pricing in the fact that you may be wrong, and could therefore lose up to 100% of what you invest in the trade if the position goes against you, and so you reduce your position size accordingly. Compare this to conventional stock trading, whereby you tell yourself that you’ll stop out if the stock goes down to a certain level, but in practice you’re not in control of your emotions, and let the position go against you more and more, until you finally pull the plug on it, by which time you’ve lost so much more than you ever intended, or expected! – And the beauty of options is that the gains can be substantial – truly more profits, using less capital, while taking less risk!
Watch the 20min video below which demonstrates how options are valued, with examples to aid your understanding…Options Made Easy
Excited? I was too when options were first explained to me!
Now, the main point for you to walk away with, is that options can only be used successfully if you can predict where a stock will move with accuracy. If you’re guessing which way a stock will move, options will knock you outta the game pretty quickly, because you’ll be losing 100% far too often.
There is (and should be) no guessing in trading.
Join now and learn to read stock charts and trade options and with amazing accuracy.
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