Uncle J, asked his nephew, “Why Isn’t Everybody Doing This?”
Most people don’t understand how a person can make more money in options rather than in purchasing stock. The purpose of this article is simply to show how options values are affected by the underlying stock values. It all seems complicated – though it really isn’t – and this is probably what scares most people away from investing in options; the FEAR OF THE UNKNOWN. When there is fear of the unknown … there is automatically FEAR OF LOSS.
We’ve all heard of great investors telling you to invest only in companies you understand. To invest with five to ten years in mind not five to ten days, weeks or months in mind. In other words … for the long-haul. While I will admit that investing with the long-haul in mind may be good for real estate … it does not hold water when talking about options because options eventually will expire and many will expire worthless. Especially if the stock that is underlying the option goes down and not up during the time you hold the option.
I realize you can purchase options on things other than stocks … such as Indexes or Exchange Traded Funds (ETFs) … but for the purpose of this article we will be talking only about stock options.
Next I am going to show you two options chains on Walmart Inc. (WMT) – a company that many get very familiar with especially around Christmas time. The last price for Walmart Stock on Friday (11/29/2019), this is December 1, 2019, was $119.09 per share. This means (not counting commissions) if you wanted to purchase 100 shares of Walmart Stock on the open market it would cost you a minimum of $11,909.00. What would happen, if let’s say the next 40 to 80 days, that stock went up in value by say 10%? You would make about $1,191 on your investment (if you elected to sell it). However, if the stock fell by 10% over this period of time you could lose $1,191 (if you elected to sell it). Now I say if you elected to sell it, because you really do not make or lose anything on stock until you do sell it. Until it is sold it is UNREALIZED gains or losses.
In this chain I have X’d OUT the PUT Options because all this article is going to deal with is Call Options. You would buy a CALL option if you truly believed the stock was going up in value. You would buy a PUT option if you believed the stock was going down in value or if you wanted to add a little insurance to protect gains you’ve already made on stock you hold (more on this in another article).
As I told you earlier … WMT closed at a price of $119.09 on Friday. If you thought the price was going to go up in the near future you may purchase an AT THE MONEY CALL (ATM) of about $120 per share. If you purchased the Jan 17 2020 – $120 Strike Price – it would cost somewhere between the Bid and Ask Prices of $2.08 to $2.13 per share. If you are buying “at the market” you will pay the $2.13 per share. Most investors will enter a limit order of somewhere between the bid and ask price to get the best price possible. If you were on the other side selling this option you would sell at the Bid Price (the lower price). The spread between the prices (in this case a nickel) goes to the “Market Maker.” Yeah, they make money on every trade whether you do or not. Always remember that.
To keep it simple, I will use the ask prices here. Again, you could purchase the 01/17/2020 $120 Strike for $2.13 per share (or since each contract is valued at 100 shares you would invest $213 – not including commission – to control 100 shares of stock). If you were purchasing the 02/21/2020 $120 Strike the cost not counting commission would be $3.95 per share or $395.00.
How much would you lose on the stock if the price dropped ten percent to $107.18 per share? Remember it would be $1,191. How much would you lose if the stock went to $0.00 (which is likely not going to happen with Walmart)? The entire $11,909 invested.
What is the most you can lose on the options?
- With the January Option the most you can lose is the $213 that is invested (about 1.8% of what it would cost you to purchase 100 shares of the stock).
- With the February Option the most you can lose is the $395 that is invested (about 3.32% of what it would cost you to purchase 100 shares of the stock).
So far … where is your greatest risk of loss? The investment in the stock or the investment in the options on the stock? But there is more to understand …
There are four greek terms that confuse a lot of people that are looking into investing in options. If you did not study greek in college and was not a member of a fraternity or sorority … I can understand the concern. But take it from me … a boy who never set foot in college for more than 6 months … there is really nothing to be concerned about.
I’m going to cover only two of the Greeks here (Theta and Delta) and will not talk about the other two (Vega and Gamma – and one of these two is not really greek from what I understand).
Delta serves two purposes:
- First to tell you how much your option should gain in value for every 1 point (or $1) gain in stock price, and
- To provide you the chance that the stock price will reach or exceed the strike price of your option by expiration.
You will notice above that the Delta of the January $120 strike is $0.47 … meaning the $2.13 you paid for the option should grow by 47 cents for each dollar the stock goes up in price or lose 47 cents for each dollar the stock goes down in price. Also it is used to tell you there is a 47% chance that your option will be in the money (meaning the stock is priced higher than the option strike price at expiration).
The Delta of the February $120 strike is $0.50 … meaning the $3.95 you paid for the option should grow by 50 cents for each dollar the stock goes up in price or lose 50 cents for each dollar the stock goes down in price. Also it is used to tell you there is a 50% chance that your option will be in the money (meaning the stock is priced higher than the option strike price at expiration).
Theta is theoretically how much will the option lose daily if the stock does not go up in value based on the current price, volatility and time remaining. This value does change daily. Based on the chart above the $120 strike for the January Option will lose about $0.029 cents per day whereas the February $120 strike will lose a little less (since it has a little longer to run) about $0.028 cents per day.
Theta is not a linear Line … nor is the value decrease in the option price due to Theta. Take a look at the following chart for the February Option shown above.
Notice how it could take roughly 56 days to lose 50% of the value and the remaining 50% is gone in the remaining 26 day time frame. With a call option if the stock is not growing … your option is like an ice cube that is melting.
Following is a risk graph for a longer term Walmart option which I will show fully later … but I annotated this one to show you how it works.
This chart is telling us many things. First of all it is telling us that there is a 68% chance that between today and expiration date (which in this case was way out in 2021) the stock could close at between $104.46 and $141.16 (two purple vertical lines). It also shows the current price to be $119.09 (Black dashed vertical line). The solid blue line represents the option price as the stock moves up and down and the dashed blue line represents the profit in the option or gain. The red vertical line is the line I set to see how the profit would change as the stock price changed.
You will notice that if this stock goes to $130 per share between now and expiration, the investor would have a gain on his option of about $692.85.
The benefit of Longer Term Options (LEAPs)
I prefer, when I am buying an option, to look longer term than just 1, 3, 6 or 9 months out. This is not to say I will not speculate in some short-term options … but much of my portfolio is in LEAPs and I would suggest all beginning options investors start there as well. LEAPs stands for Long-term Equity AnticiPation Securities and generally have expirations of one year or longer. This gives you the ability to put time on your side rather than against you. Now, if I am selling options … it is right the opposite. I want time against the option buyer, so I will only sell shorter term options.
So let’s look at the LEAP that I am considering on WMT for this article.
Here we are looking at the January 15, 2021 WMT with a strike price of $120.00. The bid is at $9.70 and the ask is at $10.00. If I were putting in this order today I’d probably put it in with a limit price of around $9.85 which is midway between the bid and the ask.
If I could get it for $9.85 a contract of 100 shares (the minimum) would cost me $985 since my broker does not charge a commission.
Now for the full chart that I cut short above …
As you can see, if the stock only moves to $130 per share … I could sell my option for a total of $1,677.85 which would represent my cost of $985 and my profit of $692.85 or a Return on Investment (ROI) of 70.34%. This while the stock increases from $119.09 to $130 or a ROI of 9.16%. What means the most to you … a 9% return or a 70% return.
If the stock goes up about 26% to $150 per share … you can see my profit would be about $2,500 or a ROI of about 253%. Not bad again considering the stock only increased 26% in value.
The key … the most I could lose with the option would be the $985 invested. That would be equivalent to purchasing the stock and loosing 8.27% of the purchase price. My opinion is that if a person cannot afford at least a 15% loss in stock (which is where I normally set my stop loss orders) they should probably not consider the market at all.
So, how would we do with a short-term option. Take a look:
If you examine this chart we see that buying the February 21, 2020 option – which only has 82 days to expiration – could make you a tidy sum of $200 to $350 of profit on an investment of about $390 … if the stock moves up $6 to $11 in price over the next 2 months. If it goes down … the most you stand to lose is $390.
If the stock can shoot up to $130 before expiration of the option … the investor stands to record a windfall return of $753.61 on his $390 investment for a ROI of 193.23%. Non bad for a 80 holding. Do this every 80 days and pocket returns of 882% per year.
Remember though … the time is short. Your chances of larger earnings are on short-term options … but I still like the long-term. Even though they cost a little more I always have the right to sell them early and do them again at a higher strike and make more money.
Above is an example of a real portfolio that is only 8 days old counting two weekends. The investor invested $30,000 into an account and purchased 9 different options on 9 different stocks (which stocks does not matter) by investing $13,549. That investment is now worth $14,554 so ROI is currently 7.42% in 8 days and tracking 358% for the 12 month period.
Let me close with the way I started: Why isn’t everyone doing this?
Have a great December and Make some Waves …
Jerry Nix |© Freewavemaker, LLC
The information shared in this article is not meant as investment advice. Before acting on any of these investments referenced herein that was meant for education only, please check with a qualified professional like a financial planner or broker that you may be working with. These investments may not be right for you at this time.
The writer of this article owns investments in the following currently: None of the stocks mentioned in this article at this time. He may or may not purchase options on Walmart in the next 24 – 48 hours.