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1.3 Stocks vs. Options

Now let's talk about the differences between stock trading and options trading. However, one thing must be clear from the outset. In no way am I going to try to denunciate stock trading here. This type of investment has its raison d'être and I also hold various stocks for various reasons. So there is no reason to demonise stocks. Nevertheless, I am of the opinion that trading options - bad wordplay - offers more options, more opportunities and less risk than trading stocks. However, this statement is only partially correct. Many will now argue with the danger arising from the leverage effect. Let's look at the whole thing together and then you can form your own opinion.

With options we have the possibility to use the leverage to our advantage - but it still holds a certain danger. The leverage effect can work for and against us, but if you are able to understand the mechanics behind it, levers are a great tool - not just in crafts. However, one of the most important advantages of option trading is exactly that - in leverage - because you can use it to increase your return and reduce your risk at the same time. Nevertheless, caution is advised. A hasty action transforms these advantages into disadvantages. However, we will discuss all this in detail. Another advantage of options over stocks is the following. If you trade stocks, you have only a very limited choice of options - you can buy or sell stocks (short selling not necessarily included). When you trade options, you have a huge toolbox from which you can serve yourself. This gives you the ability to create a strategy that exactly matches your assumptions about the stock, your risk appetite, your account size, etc.

Consequently, you are no longer limited to buying or selling, but can react depending on the situation.

There are many different ways to develop complex strategies that you can use to your advantage. They are not limited to deciding whether the stock price will rise or fall. You will also be able to make a profit if the stock just doesn't move at all. The toolbox gives you all these possibilities, which, once you understand them, can be chosen to suit any situation. But more about that later, let's take another look at the advantages of stocks first.

Figure 1 : CatchMark Timber Trust Inc. (CTT), Price in USD, date: 15.02.2019

Source: Yahoo Finance

Imagine you want to buy the above stock. The advantage of this is that you have unlimited time to be right. This means that you could buy the stock today and wait ten years to be right or you could be right overnight or never. In principle, however, you have an unlimited period of time as long as you keep the stock. From my point of view this is the biggest advantage of shares, apart from dividends or special distributions, with which you can generate a nice additional income over the years. Nevertheless, in order to acquire 100 shares in the example of CTT Inc. shown above, you would have to spend 935 USD. So buying shares is very capital-intensive. This is still a comparatively small stock, since companies like Amazon or Google are quoted at well over 1,000 USD per share. If you buy the stock now, you can only earn money if the stock continues to rise.

Well, when it comes to options, there are several ways you can approach this. Let's take another look at the chart. Depending on which strategy you choose, you can benefit from rising and falling prices. You could also choose an area where you would like to be profitable. Let's say that you don't care what happens to the stock - you don't put an increased value on whether it rises or falls. In such a case you set a highest and a lowest point, which must not be breached. If the stock is quoted within this price range at the expiration of the option, you will receive money. So you earn money regardless of whether the stock goes up, down or sideways. In this case one speaks of a strangle (but there are several strategies that work similarly). Sounds too good to be true, doesn't it? I will show you in the course of this book that this is easily possible and very profitable in the long run.

Hopefully this was a good example of why options trading should be considered and what explains the fundamental differences between stock trading and options trading. As I said, stock trading is justified, but for investors it is a binary event and very capital intensive. You have to buy the stock and choose a direction - up or down. By trading options you can use the leverage effect, which means that you can raise less capital and control many more stocks according to your own chosen strategy. This reduces the risk and increases the potential profit because you benefit from multidirectional stock movements. The stock goes a little up or a little down or stays close or runs sideways and simply does nothing. You can use a strategy at any time to profit from this scenario.

Please don't feel overwhelmed at this point or think of witchcraft because your world view has been turned upside down. We will deal with every tiny detail, so that at the end of the book you have a solid understanding and are able to hold your toe in the water. Trading options is a purely mechanical craft, free of emotion, as long as you stick to the mechanics.

Let's sum up the most important things. When you first hear about trading stocks and options, you'll probably be told that the safer way is trading stocks. "Options are too risky! - the rate is all too well known. This raises the question - what is risk? Are options really riskier than stocks? In the course of this book you will come up with the answer alone.

When it comes to stocks, most investors only buy shares if they think the company is growing strongly and the share price will rise. This is also called "bullish". Once you buy shares, they are yours - until you sell them again.

An interesting aspect of owning shares is that there is no limit to how high the price of a share can rise. You can sell the stock at any time when the market is open. If you sell the stock at a higher price than you paid for it, you make a profit. So trading shares is basically very black and white - the maximum loss is known at the time of the takeover and can be calculated by multiplying the number of shares purchased by the share price. In this sense the purchase of shares is quite capital intensive and you can only earn money if the share price rises. I'm sure I won't tell you anything new, you probably already knew that.

Of course, there is also the so-called short sale, i.e. the sale of shares that you do not actually own. As mentioned in the previous section, you are long when buying shares, because you assume that they will rise. Whether you like the company or believe that part of the company will drive up the price, you assume that you can buy now and hopefully sell later at a higher price.

As a seller, you accept the opposite side of this transaction. If you think that a company has reached its peak or is likely to decline in the future, you could benefit from a sellout with a short position. Selling something is also known as "short" in the investor's world. Short selling gives you the right to borrow shares and sell them at the current share price. In the best case, you sell the shares at the current price and buy them back later at a lower price. Since you want the stock to fall, you are “bearish”.

It is important to remember the risk of selling a stock. As with buying stocks, selling stocks short can be very expensive. The fact that there is no upper limit to the stock price is still true, but in this case it also means that there is no limit to the risk of losing a stock, as you may have to buy it back at a higher, undetermined value. Just like buying stocks, you have to be right about short positions to make money, so the stock has to move in the direction you forecast. If you sell 100 shares at 100 USD per share and this rises to 110 USD per share, you would have lost 10 USD per share because you sold it short. In this example, this would mean a total loss of 1,000 USD.

Most investors still regard equities as a long-term investment. Even if we decide to buy and sell them more often, it ties up a lot of capital, even in a margin account where you would normally only have to invest 50% of the value of the shares. At the same time, it is extremely difficult to determine the price direction of stocks correctly and consistently. This is one of the reasons why we trade options. Trading options allows us to change our attitude of "Where do I think this stock is going".

In contrast to many short-term equity transactions, trading an option is not just a 50/50 bet. Our option trading style allows us to choose different prices to become long or short stocks, known as strike prices. This allows us to make money even if we go straight in the wrong direction! We can make smarter trading decisions by setting clear goals and defining exit strategies. Since option strategies themselves usually require less capital than the equivalent of 100 shares, traders can use option strategies to do more with their money.

Enough talk, let's dive into the world of options and see what is really behind all that is said.

Remember:

Options offer significantly more application possibilities than pure trading in shares.

Thus strategies can be adapted/selected rather to the own opinion.

Options benefit from the leverage effect and tie up less capital.

Options should under no circumstances be confused with warrants or other derivatives such as knock-outs.

2. Basics
2.1 Main Features of Options Contracts

I think it's really important to understand the basics of something before you go into depth. No one is helped to build a house on a shaky foundation. That is why I am going to go over the characteristics of option contracts here.

An option contract consists of several components. First, the actual share on which we want to write options. Since these are not always equities, but can also be futures, we will use term underlyings. This could be an ETF ETN ETC / Futures or any other tradable product. So, first we choose the one we want to trade. All the following factors depend on this basic selection. The second part is the expiration date. As the name suggests, this is the day on which the option contract ends. Usually such an expiration date is always the third Friday in every month. Nevertheless, there are exceptions, for example, some underlyings have an expiration date every Friday, while the SPY (= ETF on the S&P 500), for example, has an additional two-day and quarterly expiration date. Futures are a bit different again, but they are not the subject of this book. For the sake of simplicity, however, we will be recording the third Friday of the month. So now we know which stock we want to trade in which cycle.

The third part of the contract is the strike price. This is the price at which you agree to either buy or sell the underlying shares in the future. Remember, this is not the price at which the stock is being traded. Let's say the underlying is trading at 50 USD. You are not forced to choose this price, but can say, for example, that you would only be willing to buy shares at 40 USD. The fourth part of the option contracts may seem a bit abstract at first, but you've already got to know it. This is the choice of "type". This simply depends on whether you want to trade call or put options. Basically there are only these two types - calls or puts. The big difference lies in how, in what way and in what relation to each other you use them so that they can unfold their full effect.

The last and fifth part of an option contract is the premium paid or received by the contracting parties. Remember, if you are an option buyer, you would pay a premium for this option contract in this case. If you are an option seller, you would receive the corresponding premium. That much has already been said at this point. You usually want to be on the option seller's side, collect premium and not spend them.

Premiums and options contracts usually have a 100-point multiplier (except for futures, for example). For example, if you see a premium of 1 USD, the actual value of the contract is 1 USD per share * 100 shares, or 100 USD. The displayed price refers to the premium for one share. An option contract always consists of 100 shares, therefore the multiplier comes in play.

In the course of time, we will get to know each of these components in greater detail, so that at some point an understanding of the big picture will emerge. Otherwise you will also have the opportunity to go back a few pages at any time and read them again.

Option-Chain

The above-mentioned information must now be presented in a clear manner so that every reader can understand and comprehend it. Also, I've already told you that it's possible to trade options without ever having to see a chart. To do just that, there is the so-called option chain.

An option chain is a matrix list for a single underlying that displays all puts, calls, strike prices and price information for a specific expiration period. The majority of online brokers and stock trading platforms display option prices in the form of an option chain with real-time or delayed data. The chain display enables fast scanning of activities, open interest rates and price changes. Traders can find out about the specific options required to fulfill a particular option strategy.

You can quickly find the trading activity of an asset including trading volume, premiums by strike price and expiration months. The data can be sorted by expiration date, most likely to the farthest away, and then further refined by exercise price - basically, in most applications, you are free to design your "chain" as you wish.

The terms in an option matrix are relatively self-explanatory. An experienced user can quickly decipher the market about price fluctuations and high and low liquidity. This is important information for efficient trading and profitability, and you'll find that this interpretation will become flesh and blood over time.

As a rule, you have four columns that you can determine, or you can decide which information is important for you. There is no general solution here, as every trader values different information and uses it for his interpretation. Each line and its meaning will be explained to you in detail throughout this book, so that you will be able to make your own informed decision. In order not to put you under any further torture, here is a screenshot of what such a option chain might look like in reality.

Figure 2 : Option chain of the SPY

Source: Screenshot, Brokersoftware Tastyworks

Remember:

An option consists of five main components:

Underlying Expiration date Strike / Type and premium.

A standard option has a multiplier of 100.

An option chain provides you with all relevant basic information at a glance and according to your preferences.

This allows you to trade options without having to see a single chart of the respective stock. This removes (in principle) all emotions from your own trading.

2.2 Basics: Call vs. Put

As you've already noticed, there are only two types of option contracts - calls and puts - and all you have to be able to do, in a nutshell, is deal with them. Let's go a little deeper into the matter. But for this moment let's limit ourselves to long calls and long puts.

The long call option is the basic trading strategy where you buy a call option with the expectation that the price of the stock will rise well above the strike price before the expiration date. This means that the more the price rises from your chosen strike, the more the option will be worth in the end. However, you must first select this strike price. You can choose a call option that is either "on or in the money". If you can't wait what this means, please turn to the chapter "Moneyness". An option at the money, i.e. at the current price, will rise in value earlier than an option further out (in this case above the current price). But the former is much more expensive. Let's say a stock is currently quoted at 30 USD and you have chosen a strike of 40 USD, i.e. a strike "outside the money", because you are very optimistic about the future of the stock.

Now, of course, your expectation is that the stock price will at some point in the future be well above the 40s price before it declines. If the stock price is about 30 USD at the moment, you hope that the price will rise above 40 USD over time, because this is your "starting point". Only when the price exceeds USD 40 you start earning money. This is primarily due to the intrinsic and extrinsic value, which we will discuss in detail later. Compared to the direct purchase of shares, the buyer of a call option uses the leverage effect mentioned above, as one contract moves 100 shares at a time.

The maximum loss on call options is limited to the amount of the premium you paid for them. What exactly does that mean? It can happen that you still hold the call option and the stock is below your strike on the expiration date. The option would then expire worthless and the loss would be the price paid for the call option. In our example here we assume that you had to pay 2 USD for this option contract. According to the conversion you already know, you would have paid 200 USD, which is your maximum loss.

Also the positive case is logical and easy to understand. If you assume that the stock will be far above the exercise price of 40 USD, this would be a good thing for you. Let's say the stock is 50 USD on the expiration date. You now have the right to exercise your option and would immediately collect the 10 USD difference. By the multiplier we speak of 1,000 USD.

But what happens if the stock were quoted at 30 USD? We have already said that you would have to accept a loss of 200 USD. Remember the example of the cheeseburger voucher. The stock is now quoted lower than you thought. Why should you buy it now, when your voucher is 40 USD and you could buy it cheaper directly from the market? In this case your option has expired worthless.

I think here again some of the benefits of the reduced risk features of option trading come into play, because now you would be happy to lose only the 200 USD instead of the loss you would have incurred if you bought 100 shares at 40 USD and they were now worth only 30 USD. A comprehensible calculation - isn't it?

So you have a loss limit. But is there also an upper limit? With long call options, the profit potential is theoretically unlimited, since the best thing that can happen is that the stock price goes "to infinity". This, of course, is a purely fictitious consideration and will not happen. What is important is that you know that in principle there is no upward limit.

How is the price influenced at all over the course of time? Now that implied volatility increases over time, which we will talk about very carefully later, it has a positive effect on the strategy if all other factors remain the same. So an assumption ceteris paribus. This tends to increase the overall value of the long options, as the exercise price is more likely to be exceeded by the expiration date. An increasing volatility would play into your cards in this case.

Can volatility also play against me? It can do that unconditionally. If the option or stock is currently trading at 40 USD per share and the market is not volatile, which means that the stock is not really moving, so maybe a few cents down, a few cents up, then the value of this option contract drops because the chance is no longer that great that the stock fluctuates into a potential profit zone. Before criticism is levelled here, this is a simple, bold example. Volatility is by far not the only factor that affects option prices, but at this point we're just trying to put a foot in the water for the first time. All the factors are still discussed in detail later.

Over time, this has a negative impact on the strategy. This applies to all long options (long call and long put). These should not be confused with the term "being long" in equities, because options only have a limited life. As time passes, the value or time the stock needs to move into a favorable zone becomes less and less. This is called a time value (theta). This decreases every day. As soon as the time value disappears, only the intrinsic value remains - i.e. the difference between the exercise price and the current market price.

Any more that might affect my option? Yes, that's right. In addition to the fluctuation intensity, time also plays a decisive role. At this point, however, you don't need to be afraid of being overtaxed. I will explain all these terms to you in detail and you will find that the whole thing is really not difficult. Again, options are not witchcraft.

All right, let's turn things around and look at the put options. The long put option is the second option trading strategy we want to look at, where you buy a put option with the expectation that the stock price will fall well below the strike price before the option expires. If you have already gained experience in the world of stocks, the term long put will certainly confuse you. Forget for a second what you have used so far as an interpretation and get involved in the following value-neutral. Compared to short selling, you now have the opportunity to build up a bearish position in your portfolio with limited risk by using a long put option.

With a put option, you enter into an agreement with another person that states that you will sell shares at 40 USD per share in the future. This is your strike price. Let's do the whole thing again with a striking example. Imagine building a house for someone. If you agree to build the house for 100,000 USD for the contractors, they agree to pay 100,000 USD for this house when it is finished. You now conclude a put contract as a house builder.

Now it is your goal and task to build this house for less than 100,000 USD - materials, labor, permits, everything - you want to spend less money, buy the material cheaper and just hire the people to build the house for less than the agreed price that has already been agreed. So if you manage to finish the house for 80,000 USD for example, you still sell it for the agreed 100,000 USD, the difference is therefore your profit. I'm sure this example sounds logical, but if you can't quite convert it to put contracts yet, then that's no big deal. We will often come into contact with this principle, so that you don't have to understand everything at the first attempt.

So, again, just this time without houses. You sell a stock at a certain price in the future and hope that you can buy the stock at a lower price in the future. This means that the value of the stock decreases and therefore your profit increases incrementally. So a classic short sale.

Let's give another example with numbers. Let's say that a stock is quoted at 50 USD and we want to buy a put "out of the money". Let's take the strike at 40 USD (the more bearish you are, the further down you would go). This means that if the underlying falls below 40 USD, we are in the profitable zone. As with long call options, you also have an integrated loss limit. Your loss only amounts to the premium paid, which was fixed at the beginning of the contract. For example, 200 USD.

However, unlike the example with our house building project, you are not obliged to buy the stock if it exceeds 40 USD. Remember, as an option buyer, you own rights, not obligations. There is no reason for you to buy the stock at 50 USD if you have speculated on falling prices.

Here, too, increased volatility has a positive effect on the strategy, just as we have seen with long call options. If the volatility increases and the market is more volatile, which means that the price could range from 40 to 30, up to 50 and back to 30, there is a greater chance that the option will continue to be profitable. Volatility, the vega, makes the option price more expensive when it rises - exactly what you want.

Well, as with call options, time (theta) also affects a long put option. With long options, both put and call, the decline in theta has a negative effect on the option price. We remember that options are finite. They have a final date on which they expire. So as time goes by, the value of those options goes down because the stocks have less time to get into the potential profit zone. So as option buyers, we always play against time, which can be very negative, especially in combination with low volatility.

Before we close this chapter, we need to look again at the breakeven of long puts, the point at which you start to be profitable. Let's stick to the above example where you bought a long put at a strike of 40 USD for 2 USD premium. Your break even is reached at 40 USD – 2 USD = 38 USD. The further the stock falls below this price, the more you will earn. However, the theoretical profit potential is limited here, as a stock could in principle also fall to 0. On the other hand, your biggest possible loss is 200 USD.

Remember:

For options, you have the choice of a strike price, you are not tied to the share price.

With long calls/puts you pay a premium that is your maximum loss at the same time, your profit is (theoretically) unlimited

Options are influenced by various factors (the "Greeks").