Some Daytraders Opt for Options
By Mark Ingebretsen
Special to TheStreet.com
7/20/01 8:00 AM ET
URL: thestreet.com
This is the third column in a series on how active traders are faring in these tough times -- and, more importantly, what's working for them. Be sure to read part one and part two.)
This week we'll take a closer look at one of the strategies many of you wrote in about: trading options in place of stocks.
Before we get into the finer points of that strategy, you should know that options can be risky and difficult to understand. In fact, they're especially risky if you don't understand them. So don't even think about trying the ideas outlined here until you've studied the free downloadable booklet Characteristics and Risks of Standardized Options. It's an excellent primer despite its boring name. Also, the educational materials available on the Chicago Board Options Exchange Web site are among the best you'll find online.
OK, enough with the caveats. Why would anyone want to trade options instead of stocks? As one trader explained, since the crash "a lot of guys aren't willing to commit as much capital to the markets. Options give them leverage."
Yes, leverage, the ability to control a lot with a little. To show how options give you leverage, let's take a look at e-business-application provider Siebel Systems (SEBL:Nasdaq). It's a fairly volatile stock that's popular with active traders for just that reason. Early on Monday this week, Siebel shares were selling for just over $45. So we'll use that as a reference price. At the same time Monday, an August call option with a strike price of $45 was selling for $5.20. Since option contracts are sold in lots of 100, that means by purchasing that option you get to control 100 shares of Siebel valued at $4,500 by paying $520. That's leverage.
The contract you bought, by the way, gives you control over the stock until only Aug. 17 -- the date this particular option contract expires. You could have chosen a lengthier expiration date and/or a different strike price. There are sometimes hundreds of different strike prices and expiration dates to choose from. For the entire list, go to Yahoo! Finance and enter the symbol SEBL.
For this example, we've chosen a strike price of $45, more or less equal to the stock's selling price. What if Siebel went down by $5? Then your call option contract would lose a good chunk of its value. But not all of it. That's because every option has priced into it something called time value, which is really just the hope that the stock will rise before the expiration date. At any rate, you'd lose a maximum of $520 if Siebel tanked and stayed below $40 past Aug. 17. Then again, if you owned actual shares of Siebel and they dropped below $40, you'd be out roughly the same amount. Moral: When you buy options, your losses are never more than the amount you paid for the contract.
On the other hand, your gains can be unlimited. If Siebel rallied from $45 to $50 -- then your option contract would increase in value by roughly the same amount or $500 for the 100 shares. In other words, a $5 raise in the price of Siebel could almost double your investment. Whereas, if you owned $4,500 worth of the actual stock and it rose by $5, you'd have roughly an 11% gain.
That's the beauty of leverage: Greater percentage gains are possible. And leverage works in the other direction, too. Traders buy put options when they believe the price of the underlying stock is headed south. "I have a couple of tech stocks I never buy," says a trader I'll call Tom. "But I will buy puts on them if I think they are overexuberant."
Put options on Siebel with an August expiration and a strike price of $45 were selling for $450 per 100 shares Monday. Buy that particular contract and you acquire the right to sell 100 shares for $45 -- even if the price plummets to zero between now and expiration. If you own a put you want the underlying stock to crash and burn because the put option contract will rise in price roughly in tandem with the decline in the stock's price. A $4.50 decline in Siebel's price could result in a 100% profit on the option contract you bought for $450.
The Swing-Trading Option
But you don't need 100% gains to make money trading options. Again, Tom writes, "In general my time frame is one day to two weeks." By holding for that period, Tom fits the definition of a swing trader. Option swing traders don't feel they have to wait until the contract expires. They'll sell it back when they reach their profit targets. And because options -- owing to their leverage -- routinely move by 10% or more per day, you can reach your profit objectives in a very short time.
A trader I'll call Todd, who works part time as a sports coach, explains that he might hold a contract for five days, for example. He sells when his profits reach 30%. "I was a long-term investor until spring 2000. I couldn't stomach the losses," he says. "This started my swing trading." Todd says he trades two to five times a week. And he says, "I spend about two hours a day between RealMoney.com, Investor's Business Daily and CNBC."
In fact, many of you emailed saying you've begun swing-trading options. That's kind of a new phenomenon. It used to be that options spreads were too wide to make swing trading profitable. However, thanks to increased competition between the six options exchanges, spreads have narrowed to as little as 10 cents in some cases. That means if you buy a contract and then immediately sell it, your loss (not including commissions) would be only $0.10 x 100 or $10. Many stocks have spreads wider than that.
Writing Options
Some of the traders who make money swing-trading options don't buy contracts. They sell them (the technical term is "write"). Ed explains: "I sell cash-secured puts at the price I would pay for a stock. I either get the stock at my price or keep the premium."
Here's how the strategy works. When you sell a put option, you give someone else the right to sell you the shares, should the contract be exercised. To illustrate, let's look at Siebel again (and I stress that I'm using it as an example, not a prediction). Glancing at a chart, you note that since late April, Siebel has dropped to $40 five times before bouncing back up once again. So for that reason, you might theorize that $40 is a good price at which to acquire the stock. With the stock trading at $45, you check the price of a $40 put with an August expiration date, and you see that the premium you'd receive is $4.10 or $410 for 100 shares.
But remember you're selling a cash-secured put -- not, heaven forbid a naked put. Because it's a cash-secured put, you want to be sure and have $4,000 in your brokerage account. That's the amount you'll need to buy 100 shares if the option contract is exercised. As Ed pointed out, if the stock hits $40, great. Because you believe $40 is a fair price to pay for Siebel you don't mind being put the shares. Conversely, if Siebel stays above $40, that's great, too. Because you still get to keep the premium.
Now for the downside. If Siebel drops below $40 and you're put the shares, your loss will equal the price you paid minus the current selling price. So if Siebel dropped to $30, you'd lose $1,000. (Actually you'd lose $590 because, remember, you still received the $410 premium from selling the put.) However, you could still do a couple of things to try to rescue yourself. Before the shares are even assigned, you could buy back the put at a loss. Or, if the shares were assigned, you could sell a covered call with an expiration date that's further away, say in November. The further out the expiration date, the higher the premium -- a strategy options traders call rolling out. A premium will help cover all or some of your loss.
It's not as simple as I just described. If it were, someone would make it illegal. To trade options and make money you still have to be right about the direction you think the underlying stock will take. Also, you need to know the degree to which the option contract will move in relation to the stock. To learn about these and other nuances of trading options, I'd recommend two books in particular: Options as a Strategic Investment, by Lawrence G. McMillan, and Options for the Stock Investor, by James B. Bittman.
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Mark Ingebretsen, author of the recently released book, The Guts and Glory of Day Trading: True Stories of Day Traders Who Made (or Lost) $1,000,000, has written for a wide variety of business and financial publications. Currently he holds no positions in the stocks of companies mentioned in this column. While Ingebretsen cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to mingebretsen@yahoo.com. |
