Learning About Stock Options
I’ve been trading stocks since 2002, when I opened an account with Scottrade (which has since been acquired by Ameritrade). In fact, here is an after-action report on a trade I did in 2003 for Group 1 Software (have no idea if they even exist anymore).
Over the years, I’ve grown pretty comfortable with stock trading. I’ve made some decent profits over the years, and have had some smaller losses, and overall have made money. I tried a few systems, but in the end I hit on my own system, which was completely unscientific – but it seemed to work. I started off with the following idea:
I am generally pretty careful about what I spend money on, so if I’m spending money on a product or service, then the company who is selling that product or service is generally doing something right. That’s a company I’d like to invest in.”
So this simple concept guided my investment decisions over the years. I pretty much gave up on fundamental analysis (i.e. poring over company reports, reading financial statements, etc.). I thought to myself “there are many smarter people on Wall Street who are doing that, plus computer programs, so what could I find that they would have missed?” The way I see it is – all the details of a company have already been researched and analyzed, and all this information has already been priced into the stock’s market value. That’s why I never bothered looking at fundamentals. For a while I got into technical analysis (chart reading), using the Investor’s Business Daily system, but it seemed to take too much time. So I simplified things and just bought stock in great companies I loved who were getting me to spend my hard earned money: Amazon, Apple, etc.
My (somewhat shortsighted) 1% Plan
In December, 2017 I had a good idea, or so I thought at the time. What if I could buy a basket of very good stocks – say three or four – and instead of holding them for a few months and aiming for a 10% to 15% gain, I only held them for a modest 1% gain? And what if I could replicate this success maybe four times per month. That would equal a cumulative 4% gain per month, and a whopping 48% annualized gain. It seemed possible, and for a while it worked. I was trading 3M, Google, Facebook, Amazon and a few others. On Google sheets, I set up a tool to automatically pull stock prices in, calculate the percentage and dollar gain, and give me a clear indication when it was time to sell. The market was doing great and my system was working!
Until it wasn’t….As the market went through a slight correction, it became harder to get these 1% gains, and the losses (which I attempted to cap at 0.5%) mounted and erased all of my profits. The conclusion was obvious: this was a risky system that would only work during very strong market uptrends, but would fail miserably in any other market environment.
Why Learn About Stock Options?
So I gave up on this silly 1% system. Until I had a thought. I don’t know exactly what triggered it, but I thought –
what if I could continue the 1% plan, but protect myself on the downside?
That was an interesting idea. I racked my brain, trying to determine how this could be possible. Short sales? Options? I had never used any of these strategies, but I had a vague idea that perhaps I could use them to either protect my capital (or perhaps even profit) if the market was not trending strongly upward. For example, if I bought stock XYZ at $100 and hoped to sell it at $101, but it went down to $99 – was there a way I could somehow limit or eliminate this loss by using stock options?
Stock Options are Complicated!!
So I started to do research on stock options. I was overwhelmed by the terminology and it seemed very complicated: buy puts, sell calls, strike price, premium, etc. – and this is just scratching the surface. I stumbled onto some great resources – but there was so much to take in – The Options Clearing Corporation, Investopedia, a million blogs, etc. Obviously I had my work cut out for me.
Learning Plan from Option Alpha
I’ve got a good plan for acquiring the knowledge I need to understand options, and how they could possibly benefit my portfolio. It comes from a good website called Option Alpha. This website offers podcasts, and one of the podcasts entitled “How to Hack the Options Trading Learning Curve in Less Than 3 Months” lays out a simple strategy. It discusses the concept of “stacking,” i.e. focusing on one topic at a time. I’m a big believer in doing one thing at a time and tuning out all the noise. So here is the three month Option Alpha plan:
- Week 1: Focus on the basics of calls and puts. What is a call? What is a put? What happens when you buy a put, when you sell a put, when you buy a call, when you sell a call?
- Week 2: Strike price – Determine what strike prices are and how they can move.
- Week 3: Premium– What premium is, how it’s payed out, who the players are. Also, focus on what is the role of the Options Clearing Corporation (OCC). For example – how is premium given and taken by the OCC?
- Week 4: The Expiration Cycle – Having a detailed look at when options expire, and when they stop trading. Sometimes, when an option expires is not always the same as when one can stop trading the option.
- Week 5: Buying to Open/Selling to Open; Buying to Close/Selling to Close – In stock trading the concept is simple – you buy and then you sell. In options, you can sell to open and buy to close.
- Week 6: Details of Option Contracts – This week you will focus on time decay, or theta (θ), and how that affects options – on the individual strike price and on different months. Option θ accelerates as you get closer to expiration and option loses more and more value every day until it becomes worthless.
- Week 7: Learn about Delta (Δ) and Gamma (Γ) – These are related and show how much you can make or lose depending on which direction the stock moves in. While you will not be able to master delta and gamma, you will want to at least understand how they work, and how these affect options, and how these change depending on how close or far out the option expiration date is.
- Week 8: Volatility – Perhaps one of the most important topics. You should learn what volatility is and how high or low volatility affects the option price. Option Alpha says “As an options trader, this is your edge in the market…This is how you make money in options, by trading the right side of volatility.” Learning where options volatility is relatively or high, or relatively low can be a very important aspect of options trading.
- Week 9: Bullish Strategies – Until a trader can understand the basics of options trading (what we will have covered in weeks one through eight), it is meaningless to talk about various options trading strategies like iron condors, butterflies, or anything else. This week we will learn about bullish strategies, i.e. strategies that take advantage of upward moves in the market.
- Week 10: Bearish Strategies – This week will focus on the options trading strategies that take advantage of a move down in the market, or stock price.
- Week 11: Neutral Strategies – This week will focus on strategies that take advantage of neutral moves in the market or stock price – iron condors, butterflies, strangles, straddles, etc. These strategies will show allow you to make money if the stock sits in a defined range.
- Week 12: Earnings and Adjusting Trades – Making earnings trades, and adjusting options trade is a high-level concept.
Learn by Teaching
Option Alpha also mentions how a great way to learn is to teach – so as I go along, I will try to write blog posts about the various topics I’m learning.