Updated: 06/28/11

Overview. This section will go over what options are, the best ways for trading options (including video tutorials), an interesting theory on compounding option trading gains, and option trading resources.

Pros. Trading options gives you tremendous opportunity for huge gains. 500%+ gains are not unheard of at all. Also, the worst that can happen is your option goes to zero. It’s not like other leveraged products like S&P 500 futures where you can lose more than what’s in your account.

Cons. Options decay in price over time. That’s why so many pros want to sell them to ignorant investors looking for a quick buck. You better have one heck of an edge in option trading if you want to overcome this roadblock.

Contracts and Strike price:

Options are basically contracts that allow a person to buy a stock at a certain price (called the Strike Price) at a certain date (expiration date).

You pay money up front for the option because you think the stock is going to either go up or down. When the stock goes up, a CALL option will go up. When the stock goes down, the CALL option goes down. Simple right?

When you buy call options, you will buy in lots of 100 (One contract=the option to buy 100 shares of stock XYZ). That means that if you see the price of the option at $1, it will cost you $100 for one contract. You now have the right (but not the obligation) to buy 100 shares of stock XYZ for whatever Strike Price you bought the options.

A strike price for a call is the price at which you could buy the actual stock. So if you bought an option on SPY with a strike of 125, for every dollar over 125, you would usually add a dollar to your option price, plus whatever premium is figured into the option pricing.

This premium goes into the pocket of the person that sold you the option. This is their reward for the risk they take in selling you the option. The longer an option is from it’s expiration date, the more premium you pay.

Example.

You buy a long-term SPY call option for $6.10. The strike is 125, and SPY is currently trading at 125. You’re basically paying $6.10 in premium (since we’re buying an option that doesn’t expire for 18 months).

If SPY just stays at 125 until expiration, the option will expire worthless.

However, if SPY should happen to go to 150, you would be up $25 per option plus whatever premium is left.

So the contract you bought for $610 turns into $2800 ($25 * 100 + $300 in premium left). That’s how you start making 500%+ gains.

By the way, the example was a real option that coincides with the Smart Money buy signal from June, 2006 to May, 2007. OPRA: SPYLU SPY December 2007 call.

The main problem that occurs with options is the fact that they expire. If you buy an option with an expiration date of October, the option will expire on the third Friday of October.

If you bought that option back in August, the option will become less and less valuable as you approach the expiration date. It’s just like buying milk at the grocery store— as the date gets closer and closer to expiration, not too many people want to buy it, and if they do, they want to get a better price.

Here’s an interesting fact about time-decay:

If you bought a stock on margin, you would have to pay interest on whatever amount you’re borrowing. If you have $10,000 worth of SPY that you’re paying 8% interest on, you’re paying $800 in interest. Both option trading and buying on margin have a cost of carry. In fact, interest rates are a key component to pricing an option.

American vs. European style options:

American style options such as OEX or SPY can be traded anytime. European style options can not be closed until their expiration date. I prefer to trade American style options since I can buy and sell them out when I want.

The price of an option is based on six different pieces of data.

1. The price of the stock. A call will be more expensive to buy as the stock rises.

2. One of the less know reasons for price fluctuation in an option is volatility. If the stock has wild price swings, the option will be more expensive to buy. For example, if a stock’s price moved 10% every day between its high and low, you can bet that the volatility is extremely high, thus raising the price of the option.

3. The strike price of an option will also be included in an option’s price. If a call’s strike price is increased, the price of the option will decrease.

4. Expiration is a key factor because people will pay less for something that will expire soon. Who would want to buy the right to purchase a stock with a strike price of $50 when there are only 5 days before expiration, and the stock is at $40?

The odds of the stock going up past $50 by the expiration date could be very bad. However, if the option was purchased with several months before expiration, you can bet that people will pay more. Therefore, the price of the option will be more expensive.

5. Interest rates and dividends play a key role in option pricing. The higher interest rates rates go, the higher your premium can be.

6. Finally, one aspect that none of the standard models can equate for is supply and demand. Just like a stock, an option can be effected by how many people are buying or selling at any one time.

Sometimes a bunch of people will buy options at the same time, or they raise their asking price. This tends to raise the price even if the stock is going nowhere.

There are several reasons why option pricing does not always follow the standard equations for pricing them. The biggest problem I see for the Black-Scholes model: It assumes that markets are efficient. they’re not!

Puts are the opposite of calls. If you buy a put, you are betting the stock will go down. When a put’s strike price is increased, the option will increase. This is because you have the right to make the writer of the put buy the stock at a more expensive price (think of it like you’re puttin’ it to ‘em). Puts are also affected by expiration, volatility, and supply/demand in the same manner as calls.

Making money:

My approach to option trading is not to exercise them— it is to trade them. My goal is to buy options on an index like the S&P 500 (using SPY) that I think are going to have an explosive movement up or down, then sell them. The signals are generated from the Smart Money indicator (87.1% winners!).

The time-decay aspect of trading options makes me buy long-term options that aren’t going to expire for 12 months or more. These are called LEAP options. I want to buy LEAP options that expire in December of the following year. That gives me plenty of time to get in and get out. We average about three trades a year with the Smart Money Index Trading System.

Making the trade:

To buy and sell options, you will need an options expiration and strike price code, and the underlying stock’s ticker symbol. That’s easy enough to get from the CBOE web site.

I usually try to buy options between $5-$10. If I buy too low, the option’s spread between bid/ask becomes too wide. If I buy too high, the option won’t compound as quickly.

Once you have the option symbol, you need to calculate how much you’re going to risk on the trade. When you have that dollar amount, you can figure out how many option contracts you will buy:

Option contracts = Dollar_Amount / Option price / 100

So if you buying $5,000 worth of a $6 option:

5000 / 6 / 100 = 8 contracts

When placing the order with your broker, you will usually use a symbol like SPYLU or you can simply enter the stock symbol, strike, and expiration info (this is how by broker -interactivebrokers.com- works).

I suggest using limit orders for buying and selling options. Options are quoted with a bid and ask price. If the spread between the bid/ask is high (more than 2% of the option price), I’ll enter a limit order between the bid/ask.

Note that if you enter a limit at the bid or ask, the option is usually executed almost immediately via the electronic market.

Common mistakes:

One of the most common mistakes for losing money on options is holding on to them for too long. Never hold on to an option in the hope that it will go back up.

Losing 40% is better than losing 100%. I have seen this happen time and time again on stocks such as GOOG. People will buy calls with the assumption that any pullback will be short lived and the stock will go right back up. Even performers like GOOG can have sideways and downtrends, so just buying options based solely on fundamentals is a sure way to lose.

I have to repeat this again: if it’s time to sell, take your loss! The Wall Street fat cats are counting on you to blow out your trading account in a couple years, so don’t make such a common and costly mistake!

Index options:

We trade options based on the S&P 500 index. This index is made up of 500 different stocks so it can show the overall trend of the market. The volume of options on the SPY is the highest out there, so the price between the bid and ask is usually pretty small.

See the Smart Money Index Trader for a description of just how big of an edge we can have. Hint: A 27-4 record with winners 4.95x the size of losers.

Turn $1000 into $124,000

in One Year.

The above options tutorial basically concluded that index options give us the biggest edge. By only trading at times when the probability for success is high, you can make a serious profit in just a few trades.

Such a high win/loss ratio actually sets up an interesting event:

Reinvest Your Profits

Instead of just trading the options with the same dollar amount, why not roll over the profits after each and every trade. As your account grows, so do your profits.

To take this to the extreme (caution if you don’t like to hear about high growth/risk plays), you could start trading with a $1000 account with the mentality that you could lose all that money. Starting off with a relatively small amount of money will give you psychological benefits because you will let the winners ride, and cut your losses only when the market is telling you to.

Here’s a semi-realistic look at what could happen when you combine a high success rate with a 100% reinvestment strategy:

Start with $1000 (minus $30 commission/trade)