Options Trading for Beginners part 2

This is part 2 in our series on Options for Beginners. In part 1, which you can read here, we looked at an example of a simple option trade. We found a stock that we thought looked like a good prospect as a buy. Here is that stock’s chart as it appeared then:

At that time the stock was at about $298 per share. It looked as though it had a good chance to go back to its recent highs around $317.80. We evaluated buying options to purchase the stock as compared to buying the stock itself. We found that we could buy call options which gave us the right to buy the stock at $295 per share for 56 days, until June 19, 2015. Those options would cost $13.80 per share.

If the stock did go up to $318 we could exercise our options to buy the stock at $295. We could then sell it at the $317.80 market price and pocket the $22.80 difference (our $317.80 sale price less our $295 option strike price). Subtracting the $13.80 cost of the options from that $22.80 gain would leave a net profit of $9.00 per share. Since option contracts are sold in 100-share lots that would be $900 profit per call option contract on an investment of $1380 per contract.

The question we left with last week was – was this a good trade?

To answer that we have to understand the factors that will determine our profit or loss.

The first of these is our outlook for the stock itself. Buying call options only works out if in fact the stock goes up. This is different from buying the stock itself. When you buy a stock, if it remains at your purchase price you have no gain or loss. As long as it stands still, if you don’t mind leaving the capital tied up in that stock (which you should), you could theoretically hold on to that stock indefinitely and never make or lose any money. But options are different. They expire. We cannot buy them and hold them so we must be right now, not at some indefinite future date.

In this particular trade, if the stock remained flat at $298.36 until June 19 our option would lose most of its value. At that time it would be worth about $3.36 per share – the amount of discount to market value that its $295 strike price represented. Although options have some enchanting attributes they don’t confer magical powers. If we use them to make a bet that a stock will go up, we can’t win unless in fact it does go up.

Using options in place of stocks does not reduce our need to be right about the stock. So let’s look a little deeper at this stock’s chart.

Free WorkshopIn our trading classes we teach the art and science of evaluating price action. We look for price levels from which a stock is likely to move higher. These are levels from where the stock made a dramatic move up in the past. If the stock is in such a zone, we evaluate the probability that the stock will take off again from that level. We call our evaluation tools odds enhancers. If these factors are favorable we can enter the trade with confidence.

One of the odds enhancing factors we look at is the speed with which the stock moved away from the price level the last time it was there. In the middle of March ACT moved quite smartly away from the present level. So far so good.

There are several other odds enhancing factors that we consider; more than we have space for here. But one of the key ones is what kind of price action is happening as the stock approaches that level from which it earlier blasted off. Ideally it approaches the level quickly and without much hesitation. If so, it is likely that the reversal will be quick and decisive as well. If it meanders slowly into the level, the excess demand that we need to fuel a new launch can slowly burn off. The level might not give rise to a new upswing at all.

Unfortunately, this second odds enhancer doesn’t look very good with our ACT example. It had been in a sideways pattern for a couple of weeks, hovering just above the price level we were interested in. So even though the options payoff looked attractive, the likelihood of our getting that payoff was not good enough. We needed to look elsewhere.

The lesson here is that we need to do a thorough analysis on a stock’s likelihood of moving up or down before putting our money down for the trade. When we are trying to use options just for leveraged speculation we need to remember this – if it wouldn’t work as a stock trade, then it won’t work as an option trade.

Next time we’ll look for better candidates and look at zeroing in on just the right option for the job.

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