Options are very tempting for beginners because you can use leverage to control a much larger position than you could otherwise afford if you bought the stock outright. Unfortunately, leverage also works the other direction, and the huge profit potential is equaled by the huge potential for loss. It is very easy to lose money on the options exchange if you don’t know what you’re doing.
A conservative approach is generally a good idea for beginners, one that limits your loss potential and helps you gain familiarity with the pricing dynamics of the options market and how trades play out under different scenarios.
With that in mind, here are two fairly conservative options trading strategies for the newbie in the options market.
Writing covered calls
Covered calls serve two purposes—they can generate income while also protecting you against loss. The one requirement is that you already own at least 100 shares of a security in your portfolio, because the underlying idea behind covered calls is that you are essentially “leasing” the price movement of your stock to another person for a specified period of time.
Let’s say you own 500 shares of XYZ which is currently trading at $100. You don’t really expect the price to move much over the next few months. So you write five call options with a strike price of $105 expiring in three months at a price of $1 a share. Remember, each options contract covers 100 shares, so five contracts equal 500 shares. You collect $500 in premiums.
One of four things will happen:
- XYZ drops and ends at $95 in three months. That’s sad, because the value of your stock has gone down, but you get to keep the $500 in premium, and the option is worthless at expiration.
- XYZ climbs slightly but fails to reach $105 by the end of the contract. This is your best-case scenario, because not only did you pocket the $500 premium, you also get to keep the gain on your underlying stock.
- XYZ goes crazy and climbs to $125 at the end of three months. This is your worst-case scenario because now you have to sell your 500 shares to the buyer at $105 a share and you lose the $20 per share gain. You do, however, get to keep your $500 premium, so there’s that, at least.
- XYZ does exactly what you thought it would do and stays fixed at $100 when the contract ends. You keep the shares, you keep the premium, and the contract expires worthless.
Some traders do a simultaneous covered call maneuver, in which they identify a stock that meets their criteria for a covered call and simultaneously buy the underlying shares and sell the covered calls. This is a baby step up from writing calls on stock you already own. For a beginner, it’s best to write your first covered calls with stock you’ve owned for a while that has appreciated in value and is stagnating. That’s the most low-risk way to enter the options market, because you’re not risking anything, but generating income on assets that would otherwise be earning little to no money in your portfolio.
In the money calls as a substitute for stock
The premium for an options contract has two components—the intrinsic value and the extrinsic, or time value. The intrinsic value is what the option would be worth if you exercised it right now. It’s the difference between the strike price and where the stock is trading. For example, if you have a contract with a strike price of $100 and the stock is trading at $110, the intrinsic value of the contract is $10.
The time value portion of the premium reflects the risk of what might possibly happen between now and the contract expiration date. Time value decays the closer you get to contract expiry. In the example above, if the contract is trading for $12, the intrinsic value is $10 and the time value is $2.
When a contract is deep in the money, the time value all but disappears, and the intrinsic value makes up all but a tiny fraction of the premium. When you have a deep in the money option, it serves as a substitute for actually owning the stock.
It works like this: Imagine you want to buy 200 shares of Google at $1,100, but you don’t have $210,000 laying around in your brokerage account. So you buy two call options expiring in January 2020 with a strike price of $1,200 for $75 each, or $15,000 ($75 x 200 shares = $15,000).
You’ll now benefit from the price movement of 200 shares of Google for a fraction of the price. Of course, you’ll lose a small percentage to time value, but it will be far less than the margin interest you’d pay if you bought the shares on margin. Now, there’s always the possibility that Google won’t hit $1,200 by January 2020, but the other thing to keep in mind is that you can sell your contract to close your position at any point before expiry if you feel skittish about where the stock is headed. You might take a loss, but then again, the point of a conservative options strategy is to make conservative choices about the stock you’re replacing with options.
The bottom line with options is that the only way to learn it is to do it. If you start with one of these two strategies, you’ll get your feet wet without exposing yourself to excessive risk until you’re comfortable making higher risk-reward trades.