Establishing Terminology
I have received some
feedback and words of encouragement.
Thank you!
What are Calls and What are Puts?
Call Option - The
way I think about it, is that if I own a call option, I have the option to buy the stock at a certain price. This specified price is called
the strike price. If you're speculating
that a stock will rise in value, you can buy calls at a fraction of the stock
price and sell the option when the stock price has risen. Wow, that's great, why doesn't everyone do
that versus buying stocks? Because
options have another very important component that stocks do not have:
Expiration. An option can expire
worthless, and it can be a very risky endeavor to see your account go from
$1000 to $0 on expiration day.
If I own a put
option, I have the option to sell the
stock at a certain strike price. Think
about this as an insurance policy, or hedge against losing money. For example, if you own 100 shares of Intel
and it is currently trading at $60, you could buy a put option with a strike
price of $60, in the event that Intel stock falls below $60 within the
timeframe of the option, you could put it to
the person who sold you the put option at $60, the strike price. In other words, the other person has an obligation to buy your Intel shares at $60, even
though it is no longer priced at $60.
The two examples
above describe buying the option. As I
mentioned in the last post, I sell put options.
I am the person who has an obligation to buy the shares. Another way to think about it is: I'm issuing
the insurance policy. Why would I do
this? Because I collect the premium that
is associated with the insurance policy.
My Rules on Selling Puts
- Find companies for which you wouldn't mind owning the shares
- Volatility should be a little bit high (otherwise, you would not have enough premium to make this process worthwhile)
- Cash Secured Puts - There should be enough cash in the account to cover buying the shares, in the event that the stock falls to below your strike price, and you are forced to buy the shares. This probably occurs in about 10% of the time, but it is important to keep in mind, for a money management perspective. I'll share an example on this when I traded ENPH this past quarter.
- Sell PUT option with a delta of 0.90 (see Delta on investopedia)
Option pricing for PUT options
Option premiums are influenced by: the stock price, volatility and time decay.
- If the stock price is higher than the strike price, the intrinsic value is $0
- As more time passes, the option premium will decline. So at option expiration, if the stock price is above the stock price, then the option price for a PUT will be zero. Also known as expiring worthless.
My goal is have the
option expire worthless. The downside of
this type of trade is that if the stock takes off, you're losing out on the
upside gains because your gains are capped with the premiums that you've taken
in.
When it works really
well, is when the stock is moving horizontally and the price is not really
going anywhere. Then you can capture the
option premium week after week. However,
when this is happening to a particular company, that would mean the volatility
on the stock is probably quite low, as such we wouldn't reap a great return on
the option premium. That is why I
usually trade during earnings cycles, where there is a flurry of activity and
quite a few speculators on either side of the stock.
Earnings season is
beginning soon. I would like to post
somewhat frequently and share what I'm doing.
But the posts may be shorter.
Ping me if you have any questions or want to discuss!
Next week - I will share my experience trading ENPH, the good, the bad, and the recovery.
