OPTION BASICIS (Part 1)
W. Henry Ford II
I get more inquiries about options trading these days then anything else. Primarilly
from people who have either attended a Wade Cook seminar or read his book and want
to write covered CALL options. Some have made some money, most have broken even or
lost. I figured that it would make a good topic to post about, and maybe clear up
many people's questions, and misconceptions of trading stock options. ( And maybe
slow some of the calls)
Who Trades Options??
Some try to play for quick rewards during the last three weeks before expiration.
Usually they "luck" out the first time they do this and then lose the rest
of their bankroll in ever increasing increments as they try to get even or "make
it all" in a couple of killings. Others use options as insurance against stock
which they may hold, thus diminishing their profits, when there are some.
Others play the latest straddle or strangle techniqUe they've heard from their broker
which soon separates them from triple the normal commissions and little profit.
Many try to play on the inequities in various priced options in the waning weeks
before expiration. This is a dangerous game that requires full attention to the market,
real time, money management, and guts. Most people, whether they want to admit it
or not lack one or more requisites.
I play options every chance I get as a simple proxy for the expensive stock I would
like to hold without being required to tie up a commensurate amount of capital. Yet
I risk no more than I ordinarily would AND MOST OF THE TIME FAR LESS.
Why Do I Trade Options
THE STOCK: To get 1,000 shares of a $70 + share stock, I would have to put up over
$70,000 plus commissions. I would be prepare to risk roughly $7,000 on this trade.
THE OPTION: For about $7.00 I can probably buy a CALL option on that same stock,
($5 in the money) at a strike price of $65, (meaning it has a real, (intrinsic),
value of around $5.00 REAL money TODAY. 10 contracts, or 1000 options will cost me
about $7,000 plus commissions. If the stock goes up I will make about the same gain,
without even risking the whole 7k because I use strict stops, and I conserve time
premium. (more on stops later...)
The only disadvantage is that I cannot hold the stock indefinatley...I have an expiration
date by which I have to sell...
HOW DO I USE OPTIONS??
(1) I give myself plenty time for the stock to appreciate to an acceptable price
objective before being forced to sell, by only purchasing options that are at least
3 to 6 months out from expiration...
(2) I ALWAYS buy at least $4 or $5 "in the money" to be sure that when
the stock moves up my option will increase in price along with the underlying stock.
(3) I never hold an option closer than 30 days to expiration and usually am out of
the trade long before while I still hold most of my premium.
(4) I only buy options on stocks I select independently. I never buy an option because
it looks undervalued or "cheap'
(5) I only buy as many options as I would be normally willing to buy shares of the
same stock. Notice I DID NOT say that if I was willing to invest $50,000 in a particular
stock that I would buy $50,000 worth of options contracts. Rather, If I was willing
to buy 500 shares of stock at $100.00 I would ONLY buy 5 contracts, (500 options)
at an investment of only about $3500 for about the same amount of control with actually
LESS downside risk. (we will cover money management in another message).
WHY??? - COMMON MISTAKES!!! (Why people lose money in options)
(1) Most people get lured into "out of the money options" because of the
low price.. They will buy 100 contracts (10,000 "options"), $5 out of the
money, at 35 cents each for $3500, 3 to 6 weeks before expiration. They think that
for each $1.00 the stock goes up their option will go up almost that much, so even
if the stock only went up a dollar they can make almost $10,000 and get out quick.
RULE OF THUMB, (a generalization by definition)....
If you buy an "out of the money"option:
At $5.00 out of the money, (a strike price $5 above the current stock price), the
average movement of the option for each $1 move of the stock is going to be ONLY
25 cents.
At Even Money, (Option strike the same as the stock price), the option will move
about fifty cents for each $1 of stock price movement.
When you buy in the money options:
At $5 in the money, (option strike $5 below the stock price), the option will move
about 75 cents for every 1$ the stock moves. As the stock move higher, the option
will move closer to parity.
It is only at about $10 in the money where the stock and option will begin to move
close to parity.
None of these scenarios takes into account the decay value of the option as it nears
expiration. In the 4 weeks you wait for the 35 cent option to reach expiration, it
will lose all of it's PREMIUM, (which is nothing more than the "rent" you
pay to hold the option).
That means that the stock MUST go up at least $1.50 JUST TO PAY FOR THE PREMIUM ON
YOUR 35 CENT OPTION BEFORE YOU ARE EVEN IN A POSITION TO MAKE 1 SINGLE PENNY. When
you factor in the commissions and loss of capital use, you can begin to see that
it is a big hole you have chosen to climb out of.
So let's step back and take a look:
Does this seem wise to you? Not unless you have some truly inside information..(in
that case send me e-mail....NO Don't bother, I don't follow hot stock tips).
Go back and re-read the "HOW DO I USE OPTIONS?" section of this message.
It should start to make sense to you..
= WHAT IT ALL BOILS DOWN TO:
We have generated well over 200% for the last 5 years trading the option tactics
(that you read above) on the stocks which my system selects.. I work the system only
once a week, and have been a consistant winner...
Each week on my website, I post the selections that the system makes, as they are
made each Sunday. They are purchases that I would consider picking up on Monday morning..
http://www.pitbullinvestor.com
For more info and FREE ACCESS to the picks this system makes on a trial basis, visit
the Pitbull Investor Website below:
http://www.wwfn.com/pitbull.html
We will have more for you in coming weeks on order placement, stops and money management
strategies..
Regards, and have funds investing!
WH Ford