I’ve been investing in the stock market for many years but, for a variety of reasons, I never traded any stock options. I had always had a high level of interest in options as they have limited risk with an extremely high amount of leverage, but I hadn’t gotten around to actually pulling the trigger.
I told myself in July of last year that I would give it a shot. Resigning myself to the fact that I may lose money, I viewed it as a learning opportunity. I am a firm believer that the best way to learn the rules is to play the game, so play the game I did.
This post is a look back. I’ll summarize my trades and returns over the last 6 months, then share some general lessons learned as well as go into detail into what I think is the best usage of options in stock portfolio.
Looking over my trading record, I made enough trades to have gained a decent amount of experience by trading both puts and call options on several different securities.
Here is a summary of my transactions:
||Jan 17.5 Call
||Jan 25 Call
||Jan 5.00 Call
||Apr 27.50 Call
||Not Sold Yet
||Nov 20 Call
||Jan 20 Call
||Jan 45 Call
||Feb 12.5 Call
||Not Sold Yet
||April 17 Call
||Not Sold Yet
||Jan 17 Put
As you can see, I’ve had mixed results. While my winners have outrun my losers, I don’t consider stock options to be the holy grail of making fast profits on wall street. They are complicated, volatile, and often have lower liquidity requiring you to pay more of a spread when you go to buy and sell the contract.
What I have learned from six months of options trading:
- Options are a tool you can use to maximize your investment returns
- Options can be used to minimize your investment risk
- Options can be used to leverage your cash on speculative plays
- Options are highly volatile and very sensitive to market news
- Options complicate trading by requiring that you predict both the direction of the price moment and the time frame that the movement will occur in
The largest lesson learned over the last 6 months while trading options is that stock options (either Calls or Puts) have a place in your portfolio, but should be reserved to a small percentage of your capital. Overweighting your portfolio with time and news sensitive options contracts can decimate your portfolio if a hiccup occurs in the market. I’d like to spend the rest of this post talking about what I see as the most valuable use of options in your portfolio. I encourage you to research stock options to learn about how you can effectively use them in your trading and investing.
Options have a place in your portfolio.
I will continue to use options to increase leverage in my portfolio in certain situations. There are times when the market overreacts or underreacts to a piece of news, and as an investor who believes differently from the general market, you want to act to take advantage of the market’s ‘mistake’. An effort to seize a short term gain using your own-unleveraged capital can be challenging. You may have most of your money tied up in other positions that you don’t want to liquidate for tax or fundamental reasons, or you may simply not have enough capital in your account to buy enough stock to make a significant profit. Using options to increase leverage and reduce risk on speculative plays, I view, is one of the main benefits of stock options.
Lets assume Microsoft announces earnings that upset the analysts. The price of Microsoft’s stock may sell off by 20% in one day. If you believe the sell off is overdone, you could buy the stock outright with cash and try to capitalize on the market’s overreaction. Microsoft is trading for $31/share and, after getting a 20% haircut, may be on sale for $25/share. If you believe the sell off was overdone and you think Microsoft should be around $28/share, you would want to buy the stock to take advantage of the $3 gain. To make $600 on the situation, you would have to buy 200 shares of Microsoft, this would require $5000 in cash. If that is not an option for you due to simply not having that much capital or having your capital tied up in other positions that you do not want to liquidate, you could turn to options.
If you suspect Microsoft’s price will recover to $28 in the next month, you may buy two call option contracts, 2 months out, at a strike price of $25, giving you the right to buy 200 shares of Microsoft anytime in the next two months for $25/share. You will pay a premium for this. Even though the stock is trading at $25 right now, you may have to pay a dollar per share in premium to buy the option, meaning you’d pay $100 per contract for a total of $200. Now, you control 200 shares of Microsoft stock for the next 2 months. Instead of it costing you $5000, it costs you $200. You don’t own the stock, but you have the right to buy it for $25 anytime in the next two months. If the stock goes to $28 as you predict, you can sell your call options for $300 each, bringing your profit to $400 on a $200 investment instead of making $600 on your $500 investment. You’ve seen an opportunity in the market, and you want to take advantage of it with as little money out of your pocket as possible. If Microsoft were to continue to decline and dropped to $23/share at the end of two months, instead of having tied up $5000 in capital for two months and having lost $400 on the transaction ($2/share times 200 shares), your call option will expire worthless and you will be out your $400. You’ve lost 100% of your investment, but your investment was small and you were able to keep your $5000 in other positions. As you can see, options are a powerful tool to use if you are making speculative plays. If you want to take a shot on a few speculative plays while keeping the bulk of your investment dollars in standard stock positions, options allow you to do it while limiting your risk.
I look forward to continuing to use options to increase the leverage of my portfolio and capitalize on situations where I believe the market has overreacted to certain events. While I will continue to use them, I will certainly back off of trading them so frequently. I achieved my goal of learning about how to trade options, how they behave in the market, and how they change based on the underlying stock price. While I was able to come out of my experiment with a profit, I believe the real value was in learning how to use these excellent tools in my portfolio going forward.