I played rugby in college and sporadically until age 50. There’s an old saying I often use when explaining the sport to a skeptical newcomer. I like to think that it applies to options trading as well.
“Rugby usually looks more violent from the sidelines than from inside the pitch.”
Options trading (like rugby) isn't for everyone. And to the untrained eye, rugby can seem complex, disorganized, and intimidating – much like options trading. But as you continue to study the basics and intricacies of the game, your perspective starts to shift. Instead of seeing random chaos on the field, a fluent and highly calculated game emerges. You start to find order in the chaos on the field, and eventually, you might even appreciate the madness of “the scrum”.
The same could be said about trading options. Behind that wall of complexity and intimidating jargon lies a fluent and useful trading vehicle that could potentially fit your investing needs. But first, you have to learn the basics of a seemingly complex subject.
Now, remember that rugby quote? Let’s enter the scrum.
Among the first lessons for investors and traders entering the options realm is directional bias, shown graphically by the expiration payoff chart (which, on Swim LessonsSM broadcasts we often refer to as "hockey sticks" because of their "L" shaped design). Note: if you first need a primer on call and put options, please refer to this recent article.
If you're ready to lace up and hit the pitch, here's some of what you need to know about single-leg options:
- Buying calls and selling puts are bullish-biased strategies.
- Buying puts and selling calls are bearish-biased strategies
- In general, buying options limits your risk of loss to the premium paid for the option, plus transaction costs, but your potential gain is theoretically unlimited in the case of a long call. The profit of a long put is bounded only by the stock becoming completely worthless. As an option moves more in-the-money, its payoff begins to mirror that of a similar position in the underlying.
- In general, selling options limits your potential gain to the premium received, minus transaction costs. It should be noted that while short puts technically have limited risk, short calls have unlimited risk. When you sell a call, you are obligated to sell shares of the underlying stock at the option’s strike price at any time prior to expiration. Since there is theoretically no limit to how high the price of a stock can reach, there is technically unlimited risk. On the other hand, when you sell a put, it means you are obligated to buy the stock at the option’s strike price, no matter how far the price drops. This means there is a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Since the lowest the stock price can drop to is zero, there is technically limited risk.
Figures 1 and 2 show example payoff graphs of, respectively, a long call and a short put— two alternatives to consider if you're bullish-biased on a stock.
Positioning Your Trade: Rucking and Mauling
Rugby players grapple, ruck, and maul for positioning on the field. In every scrum, there’s always a multitude of split-second decisions, movements, and scenarios that players need to consider while positioning themselves towards their broader goal. Similar to positioning yourself in a scrum, there are a ton of different factors and scenarios that you might need to consider as you position your option strategy.
If you have a directional stance on a stock and want to try and options trade, certain factors such as your level of conviction, your time horizon and your willingness to tie up capital should play into your decision. Do you believe the stock is poised for that up move in short order, but you want protection in case you're wrong? Perhaps you should consider buying a call. Remember, your risk is limited to the premium paid, plus transaction costs.
Do you instead believe an up move is coming, but not necessarily imminent, and you might be even slightly wrong in the short term? Consider selling a put. You'll take in the premium up front, and as long as the stock stays above your strike price, you'll keep the premium (less transaction costs).
But it's important to keep an eye on your risks. With the long call, the stock could rally and you might still lose money, if it doesn't reach your breakeven price by expiration. With the short put, because of the downside risk, you'll need to reserve enough cash in your account to cover a purchase of the stock if it's trading below your strike at or before expiration. Plus, your gain is capped at your premium received, less transaction costs, regardless of how much the stock were to rise.
From the Training Pitch to the Arena
Now that you've been introduced to using single-leg options for directional strategies, would you like to learn more?
Join Swim Lessons on Wednesday March 15th at 10:30 AM CT as Scott Connor and I put these concepts into practice, with real numbers, probabilities, and real-world analysis.
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