Option Trading College
Options 101

Subject: The Basics of Trading Puts Options
Instructor: The donFranko
Length: 7 sessions

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Entry is Key...Exit is Everything! TM

Session 1 -- Puts: The Basics

My absolute favorite way to play options is with PUTS!!

Why, because you make profits much faster and MUCH larger when a stock gets crushed.

PUT Options give you the right (but not the obligation) to put a specific stock onto another investor at the strike price you choose on or before the expiration day of that option contract.

Lets look at an example.

Say you wanted to short Google. Taking a look at the current price at the close of trading on 03/06/2009, it will cost you a whopping $308.57 per share...ouch! Now you might not have enough money to short a lot of shares or maybe there will not even be shares available to short, but your research has led you to believe it will drop significantly in the short-term. 

You want to short a lot of shares; however, you have limited capital, so how do you control more shares? You choose a "Put Option" as your strategy vs. shorting the stock on margin.

You have three decisions to make before you purchase an option contract.

1. You pick the month of expiration (I always recommend a new trader buys a minimum of two months out until expiration.)

2. You choose the strike price (I always recommend a new trader buys at least one strike price in the money.)

3. You must KNOW YOUR EXIT!  Notice, I did not say know your profit. If you understand the risk you are willing to take, the profits will come naturally because you have a plan of action should the trade go against you.

 

 

Here is a sampling of the current prices on Google as of this writing:

As you can see, I have highlighted the March and April $310 strike prices—the strike price is the actual price you choose to put the stock onto someone else, or the price you would short it at if you were to exercise the option before it expired.

Lets say you violate my rules for a new trader and pick the front month and buy at-the-money (ATM). In this case, it would run you $13.00 per contract plus commissions. Since a contract is equal to 100 shares of the stock, you would have to put up $1,300 per contract in order to control Google.

Note: your investment is only $1,300 per contract vs. $30,857.00 for the stock. This is the MAXIMUM you can lose; whereas, the stock could easily run up $20 - $50 plus per share on a good news story. I have seen this stock gap up and down $50 in the past, so shorting the shares is extremely risky if you cannot watch it every minute of the day.

When you purchase PUT options, you have capped your loss potential while letting your upside potential become unlimited! If Google gets crushed, then you stand to make a very nice profit, but if Google rises significantly, you have capped your loss to the cost of the option contract—short covering rallies can wipe you out very quickly.

So where is the risk? The biggest enemy of options is time decay. If you buy/short the stock, you have all the time you need to make a profit or recover (potentially) from a good or bad news story; however, If you buy the option contract, then you have set the clock running on how long you have to sell or exercise your option.

This is where many new option traders make two grave mistakes.

1. They do not buy enough time to allow for this

2. They buy out-of-the-money (OTM) options in the front month.

This is why it is critical you do your homework on the stocks you pick. I highly recommend you buy at least two months of time for OTM options. Also, make sure the stock is definitely in a down trend and even better is if its falling from a heavy resistance area—timing is critical when trading stocks like GOOG.

Here is why I say this: If the stock is at or above your chosen strike on expiration, you will lose your $1,300 investment because you paid a "premium" for the right to exercise your option at that particular strike price. Remember, you paid $13.00 for an ATM $310 PUT option. This means Google must trade under $310.00 at expiration in order for you to make a profit; however, that is not completely accurate because you paid $13.00 for the option; so Google actually has to close BELOW $297 for you to profit on this trade.

Here is the breakdown:

GOOG Last price as of this writing: $308.57

The closest ATM PUT option is the Mar 310 Put : $13.00

The actual Intrinsic value of the option: $310 (strike) - $308.57 (actual closing price) = $1.43 of intrinsic value you receive.

Deduct intrinsic value from option cost = $13.00 - $1.43 and you are paying $11.57 for Time Premium

Deduct time premium from current price and GOOG has to close below $297 in order for you to profit. 

NOTE: the intrinsic value is subjective because the stock swings in price throughout the trading day thereby skewing the actual intrinsic value you have in the option. It's a complicated mathematical sequence known as the  Black Scholes Model.

Now, when you take that into consideration, the stock actually has to drop better than 4.5% just cover the cost of the trade. Now that is a big move for any stock to make, so this is why you need to buy more time.

Today is 03/06/2009 and the March 2009 $310 strike is trading at $13.00 per contract. The market maker is bumping the premium $11 above the current stock price which translates to Google trading at $272.57 per share by March 2009 expiration. It's a scary thought to risk this much money for only 14 days don't you think?

Now if we look at the April $310 puts, we pay $24.30 and you are paying another $11.30 for pure time premium which means that GOOG would actually have to close by April expiation at approximately $282.84 just to cover the cost of the option contact. That's over an 8% drop—Hardly a good bet don't you think? This is why you should NOT trade short term ATM or OTM options on a stock like GOOG because the premium you pay is ridiculous!

If you must speculate on a stock like Google, then you need to understand why you should buy ITM options vs. ATM or OTM to have a fair chance at making a profit. Well, sort of, because there is still a gremlin in the details, and that is time decay. In order to maintain a consistent profit, Google must move down every day so your ATM or OTM option can overcome the time decay. If Google whipsaws around, then your option premium will also whipsaw. Many times a stock can go down significantly, then pull back and go up again, but your option premium actually loses value...huh?

Yes, I said loses value because, if you remember, you paid $13.00 for an ATM option in the front month. This means you have that amount of money that can disappear on you. So, as long as Google's price stays above your strike price plus the premium price, the Market Maker can manipulate the options intraday value. Of course it's all done mathematically based on the Black Scholes Model, but in reality, the Market Makers have no problem with skewing the math during the trading day... ;-)

How do you minimize this? You buy in-the-money (ITM) options. This way, part of the premium you pay is actually covered in the price of the stock. This is called intrinsic value and it's your best hedge against whipsaw as the stock moves down in value; your option premium will grow faster because you have more "Delta" (see below) working for you; and should the stock get some whipsaw, you have minimized the amount your option decreases in value.

For example, lets take an ITM April option for this example. We will go with the April $330 put options which closed at  $35.70 per contract. Since the stock is currently trading at $308.57 our intrinsic value of this option is $21.43 because you are actually $21.43 ITM, so your time premium for the option is only costing you $14.27 vs. the $310's which have a time premium of $22.87. What a difference you pay for time premium for those ATM options.

When you buy the ITM options, it gives you a little more of an edge to overcome the daily movements of the stock; and so long as it closes lower each day, you will benefit more because you have increased your intrinsic value; however, the clock is eating away at your time premium.

What about buying out-of-the-money (OTM) options? This is gambling! Many times (if not all the time) new option investors often buy OTM options because they are cheaper. Well, they are cheaper for a reason...they have ZERO intrinsic value! You are paying 100% time premium or as I call it, "blue sky". This is speculating on hope that the stock goes your way—hope does NOT float financial boats!

The reason so many do this is because they perceive they can buy more contracts for the same money invested (leverage). The only time this works out (if ever) is because the stock surpasses the OTM strike price to give you a profit. To compound this, most newbie option investors make an even bigger mistake with OTM options by purchasing the front month. If you want to have a chance to win with OTM options; then go to my training session on Hitting the Lottery if you want to learn now to make deep OTM options pay off HUGE returns.

Here is what I mean:

 

currently the front month OTM 300 Puts are trading at $8.80 which translates to Google closing under $291.20 by March 09 expiration in order to just break even, let alone make a profit. On a percentage basis, GOOG has to drop by more than 5.5% in the next 2 1/2 weeks or your money is GONE! Sure, Google can do it, but it can also pop a huge rally on any positive market or market related news.

Bottom line! Do not buy ATM or OTM when you are a new option trader. If you do, be ready to take profits sooner if the stock moves down immediately after you buy them; and I highly recommend that you MUST buy at least two months of time.

If the stock drops suddenly, take your money off the table because it will invariably pull back and your premium will shrink faster than it went up. If you manage the ATM or OTM trade, you can sell for high and re-buy for less as the month moves forward—this takes timing, experience and luck to get it right.

I have been trading options for 10+ years and I still struggle with it...so does everyone else! Save yourself a ton of heartache and stress...only buy ITM options in the front month and when you make a profit, take some of that off the table. Then you can go buy OTM options in the next month for the "Lotto" play.

 

 

 

Profits Up!

The donFranko 

 

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