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Basic Option Strategies

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110 pointskaramazov83 comments

I liked the intro. There is another use for options, which is insuring against lost gain. Allow me to share a couple of anecdotes.

In January of '95 I knew my 3rd child was on the way and wanted a 'sedan' type car to take the family out. (we had my sports car and a mini-van at the time) I was working at Sun and had been participating in the Employee stock purchase program forever, and Sun stock had gone up a bit so I sold 1,000 shares at $37/share which after taxes and fees netted me enough cash to buy a Chrysler sedan for cash. No loan, no payments, pink slip on the first day I owned it. That was an awesome feeling. In March of that year Sun announced Java, the stock ended up doubling and splitting 3 times. The car I paid 'cash' for was worth 1.6M$ (at the peak of Sun's stock value). Youch!

So my Dad's buddy, a Swiss ex-banker, chastised me for not hedging my bet by buying an 'out of the money' call option, 12 months out. He explained that if the stock never went anywhere it would lower the effective 'gain' from my sale, but if the stock went up a lot it would protect me against having lost out on that value.

Flash forward to 2006, I'm heading for Google, I've got a chunk of NetApp stock and I having lived through the dot com crash I want to diversify. So I sell a lot of my NetApp stock at $35, and buy options for the same amount of stock a year out at $40. (so 'out of the money' by $5). NetApp kept going up and up, and I sold the options a month before they were due (NetApp was trading at $55 and I wanted to keep the gain in the the right tax year) and I got a nice 'bonus' payout on what was essentially the same stock I had sold nearly a year earlier.

The option was there only to protect against missing out on a large rise in the stock price. (which it did, not as well as if I had kept it all but I didn't miss out completely either).

I found that I would keep stocks longer than I should because I was 'worried' about whether or not it was the right time to sell. Options allow you to 'buy insurance' on against that worry, and for me that has made me more willing to make significant changes in my portfolio over the years.

This is a great example of using options to lower risk. You can also purchase insurance outright against a stock falling - if you own a stock and buy puts for it, you'll be protected against the stock falling below the put's strike (since you can literally sell it for the strike price to the person who wrote the puts).

This was originally one of the main uses of options, which is why an option's price is called a premium - it's an insurance premium.

This is true for shares you own outright.

However, if it is stock that is under SEC "rule 144" lockup (which usually applies for 6 months following an IPO and most M&As), then the legality of doing that is murky.

It used to be outright illegal. The letter of the law has changed, and now it is unclear. I was in this situation, and personally couldn't find a single CPA or lawyer who would say "I believe it's now legal to hedge rule 144 locked shares". (And as a result, I didn't, and lost lots of money, and almost came out with a net loss on a x5 exit)

Not always true: even if you own the shares outright, you may be subject to obscure SEC regulations about what you can do. When I worked at BAC, we weren't allowed to engage in any speculative transactions in any security. Covered calls only.

At my current employer, no options transactions are permitted on company stock, not even covered calls or protective puts. Of course, you can just sell it and do whatever you want with the proceeds.

You should've tried a costless collar. Buy a 10%-30% falling put using the proceeds from selling a 10%-30% rising call on a stock you already own (this is critical - as it is your collateral on this trade). Your loss is capped, and you can still participate in gains (Mark Cuban did this back when he sold Broadcast.com - see here: https://www.quora.com/How-did-Mark-Cuban-survive-the-dot-com...).

If your stocks fall, your put is triggered, you sell out at a forced 10%-30% loss, however, as you still have all the cash at that level you can just buy it back, if it falls further you can just buy it back with your cash and redo a collar. If your stocks rise 10%-30%, the call is triggered, and you must sell out at a forced 10%-30% gain, but since you still have all that cash from the rise, you can just go ahead and put on another collar at the new level. Or you can just hold onto your cash.

The collar costs you nearly nothing (simultaneously buying insurance with the proceeds from selling it on things you already own), and you can move around the price levels a lot, "collaring" your wealth to 2 surety levels - aka you will be worth a guaranteed spread between X and Y.

What you wish to do with your cash after the triggers depends on your risk preference, market dynamics, your future predictions of the world economy and the company at hand.

Not a bad intro at all.

That being said, intros to options scare me in the same way a "Beginner's Guide to Fugu Preparation' would scare me: as a novice, you have no business mucking around with such dangerous things, but as an initiate, you have no need of the article.

Still, there is a readership for such things, and the author is clear to point out the potentially unlimited downside in the intro.

Now, scripting Excel with Python? I'd forgotten about these guys. My interest is officially re-piqued.

I'm guessing I'm the "readership for such things", as I don't know much about options, but also don't plan on doing much with options in the near future, either.

I'm curious to know, though, what you think I should know before looking into options?

At a minimum, know exactly what the worst case scenario is with each trade. Make sure this isn't more than you can lose.

There aren't always market makers in options, so bear in mind that you can buy a lot of options and not be able to sell them later. Worse, you can short a lot of options and not be able to cover your position, so you really do need to be comfortable with the worst-case scenario.

You should also look into the details of how your broker deals with options if you hold them until expiration - otherwise you might end up with a lot of stock you don't want (or vice versa).

edit: corrected based on chollida1's response

> There are no market makers in options, so bear in mind that you can buy a lot of options and not be able to sell them later.

Where did you hear this? While it's true that not every market has market makers, there are many market makers for CBOE and MEOP options that are blessed by the exchanges.

On top of that there are many more funds that make their living solely on being option market makers. We do pretty well in the Canadian markets.

Corrected, thanks for pointing that out. I heard an anecdote of someone buying a lot of options and not being able to close the position later - I guess it happened in an illiquid market.

Yep, it's not uncommon to look at the book for an option and see huge sizes on one side and no one at all on the other side.

Could you explain this a little better? I'm sure you're not contradicting yourself, but that's how I'm understanding it.

What risk is there of not finding the other side when you are playing the options game? In your first post you seem to imply that this isn't really a risk.

Ah, I see what you mean. Yes in this case I'm contradicting my self a bit.

The thing about options, as compared to stocks, is that they can be literally worthless. A stock that is bankrupt can still have a buy side bid of a few pennies as the buyer can hope for some cash from the bankruptcy proceedings.

Consider a Call option on facebook for Nov 16th with a strike to buy at $40.

This means you can buy facebook for $40 up until Nov 16th. Currently FB US Equity is trading at $19.50, so with 2 days left and it's historic volatility there is almost no way it's going to get to $40 and make your option worth anything.

In this case the Sell side of the book would have many offers as everyone would love to sell this call for any amount of money as it's worthless.

On the buy side you'd expect no bids as there is almost no way this could make you money.

Now when I mentioned market makers I was referring to trading options that still have some value. I assumed that the OP was talking about not being able to sell options when they had some value, in this case there is always someone willing to act as a market maker in this case.

Thanks, that makes a lot of sense.

I thought there was the implication that somehow you might not be able to exercise your option due to lack of market maker.

> At a minimum, know exactly what the worst case scenario is with each trade. Make sure this isn't more than you can lose.

This. Actually, it's not just the minimum - it is the best way, and possibly only way, in many cases.

Many traders/investors went bankrupt by assuming some statistical model of how things behave, and using this data, assumed that e.g. with 99.999% confidence, one trade's profit will be able to cover another trade's loss if things go bad. However, when things go bad, they tend to do so in ways that do not match historical patterns, and thus these models are invalid.

Also, if you are short call, long put, long underlying (in the right proportion) then theoretically you cannot lose. However, the options and underlying are likely to trade in different markets (with different rules, different margin requirements, and lacking a netting agreement), and as a result, extreme market movements may make your "perfectly hedged position" a huge loss because e.g. your underlying gets liquidated due to a margin call at the bottom of a flash crash, but your synthetic future remains; and now you're exposed.

Thanks! Using options conservatively - buying small amounts, or only writing covered options - can be a great way to mitigate the risk involved in trading just stocks.

You're right that writing naked options, or using more advanced strategies, is a great way to lose a lot of money, but commercial brokers usually stop people from doing that unless they have a good reason for it (or at least know what they're getting into).

Absolutely. Options are a tool, like any other. If you hold it wrong, though, the sharp edge can give you a really bad cut.

Buying options is a great way to derisk your portfolio, as your risks are much smaller than trading real stocks for a given position for most thing.

Now SELLING Them, that's a different story. Selling positions when you do not have the stock as security to hand over is pretty risky.

> as a novice, you have no business mucking around with such dangerous things, but as an initiate, you have no need of the article.

That reminds me of an ex-girlfriend's "if you don't already know what you did wrong, I'm sure not going to tell you!"

More seriously, somewhere along the path from novice to initiate, you have a need for some material, though - be it this article or another.

Also, I'm not implying you do, but I find it funny that many people think "stocks are a fine investment, but options are dangerous".

The only real difference in risk is leverage, which is always high in options, and usually low in stocks. But you CAN get high leverage for stock trading, and you CAN restrict yourself to a small part of your capital thus "deleveraging" the effect of options on your portfolio. You need to have some experience, but definitely of the calibre of a Fugu chef, to practice these.

I think the close proper analogy is the stocks are a sharp household knife, and options are a butcher's knife.

Ex for a reason, I see :)

There's a bit more to it than just leverage. Writing naked options carries huge potential downside, unlimited in the case of naked calls.

With a stock you're long, or short. Prices go up and down. Four outcomes to consider. Options are a bit more involved: covered or uncovered? call or put? long or short? Then you've got the option price and the underlying price to think about. Until you're comfortable, it's more than most can manage in their heads.

Since we're doing 'sharp tool' analogies, I'd be more inclined to go with hand saw and chainsaw. The level of potential harm you can do to yourself in an instant with a chainsaw is far greater than that you can achieve with a hand saw - and it's a much bigger difference than that between the efficiency of using a chainsaw and a hand saw. Yes, it's powerful, but it's disproportionately hazardous in untrained or careless hands.

I mostly agree with what you wrote, however:

> Writing naked options carries huge potential downside, unlimited in the case of naked calls.

The same unlimited potential downside exists when shorting a stock.

But you have to be a pro to get away from the risk & margin checking. (Unfortunately, it's actually possible to do that, and most pros do). And until you've escaped from it, the downside is limited to not much more than what you have put down as margin.

Good point. As you said above, it's the leverage.

Whenever you're talking about vanilla options, _always_ mention the exercise type - European or American (or Bermudan/whatever). Single-name stocks like Facebook, Google have exchange-traded options which are American. Index-options such as those on the S&P500 are usually European.

Also, it's a good intro for buy-and-sit strategies but rarely does anyone sit on options till expiry. They try to make some gamma-based profits (delta-hedged option) or some vol-based profits (strangle/straddle etc).

I'm a buy and hold long term investor for whom options seems ill suited. However sometimes I feel they might be useful to me because I could focus my investments on my area expertise and hedge against everything else.

As a developer and tech business owner I feel I have an edge when it comes to picking stocks in the tech sector. However, I'm not very good at predicting macroeconomic issues. Even though I think my stock picks will do well compared to larger sectors and markets, I'm always nervous my savings will be decimated by such things as europe/fiscal cliff/china which I'm not very good at predicting.

Unfortunately, I'm not sure how to edge against those things. I read on wikipedia that I could short sell an index or buy put options to protect me against this macro volatility but I'm not sure how to decide which to do, how to do it through my online broker, how to pick the parameters, how to decide if it's worth the premium or if it's worth doing at all given my relatively small and passive portfolio I use simply for saving for retirement.

Are there resources for simple savers like me who'd like a simple solution to hedge out a bit of the unknowns out of their portfolio and focus it more on their area of expertise?

You know John Maynard Keynes was once asked the same thing:

> Investment board: What happens if the world goes off a cliff?

> John Maynard 'The Badass' Keynes: There will be bigger things to worry about if that happens - stocks will be the least of your worries.

If the economy tanks - everything will tank. Your house, your job, industry production - everything. Trying to protect yourself from the market in this case is like those people who worry about possessions in a burning house - possessions mean nothing, just try and get out alive.

You can't hedge the end of the world. You can only prepare to die. Because in those situations - luck keeps people alive, not money. See all revolutions, the Holocaust, uprisings and rebellions. Money doesn't save you - property doesn't exist - titles don't matter - law vanishes into thin air - there are no rules and who you are means nothing.

If you're a passive investor - suck your shit up - that's your strategy. If you don't sell you'll be fine. If the world ends you'll be dead.

Currently, I'm long TSLA, and have been long GOOG and AAPL. I've had huge drawdowns - 10%-20% within a month, and I've had huge gains. My largest draw down on a position so far has been 60% - that's 60% gone into thin air. And guess what? I don't give a shit.

You ain't a real investor until you've had a position blow up in your face and drawn down nearly 100% at least once, and not sold because you knew you were right. That's the nature of the game. Investors are lonely - they look at the world and stand there and say: No you're wrong world, so very wrong, and here, I'll put my life on the line to prove you wrong.

I'm a value investor and I'm in here for the long haul. I play vol sometimes, huge drops below margin of safety I go all in, huge rises above, I'll just exit. But I'm always net long.

Everyone is always net long.

I get what you're saying. And you're probably right, my passive strategy is probably ok as it is. However, in 2007 the US stock market dropped by about 50% and stocks were indeed a worry while my employment remained relatively stable.

I sorta worry about a sovereign default cascade in europe with similar effects on stocks as the financial crisis of 2007. I'm not sure if trying to hedge for this is worth the premium though.

I always chortle when people say stocks fell 50%. If a house is selling for a trillion dollars, and it falls back to a million, would you be surprised? No.

Well then, if the market is overpriced by 100% and it falls 50% - why would you be surprised or worried. If the market continued to crash - you would be unemployed - as domestic consumption cycled down. We'd either end up like the Japanese or the Germans - either way - we'd all be fucked.

This is foolish advice - a proper hedging strategy in the 2007/2008 meltdown would have been tremendously valuable.

But I suppose that doesn't count, because it wasn't the end of the world.

> If the economy tanks - everything will tank.

What is the definition of "tank" in this context? Presumably absolute destruction? So what then about 2007/2008, what would you classify that as?

A buying opportunity.

> Trying to protect yourself from the market in this case is like those people who worry about possessions in a burning house - possessions mean nothing, just try and get out alive.

So would that advice apply to that scenario?

This is a good intro to something everyone analytical should know something about.

It's also worth knowing that overall, most options expire worthless, so apparently selling them is a better game than buying them. Also spreads are typically pretty large so trading them profitably requires big moves.

The built-in 'cost' of options and futures is of course 'time decay' as they are all dated and you pay more for a date further in the future.

I think they'd be very useful if you found yourself in a position with a large amount of restricted publicly-traded stock. I'd imagine you couldn't legally just lock in your equity by going short in a retail account but markets are so highly-correlated now that you probably wouldn't even need options on your particular stock to afford yourself some protection against many downside situations. Rather you might just own puts on the closest-related index. It won't be free of course but if you spent 5% of your position as "insurance" until you could sell it could prove to be worth it versus weathering a loss due to overall supply/demand forces that could take the sector and market down 50% or more without any substantial change in your own company's numbers.

Mark Cuban did this back when he sold Broadcast.com - see here: https://www.quora.com/How-did-Mark-Cuban-survive-the-dot-com...

The more I read about the stock market the more it resembles a complex gambling scheme to me. My view of the stock-market limited to high-school economics is the straightforward "here's how you own part of a company and how you can support a company you want", and for companies "if you do good work, people will give you more money to expand and innovate" and I think at the base level that is there, but there is this whole side-show with the gambling that now totally shadows the original intent.

And that's what the thrill of money does.

Well, more abstractly, anything you ever do is a gamble. Getting higher education? You're gambling that it'll pay off better than just working in a job that doesn't require a degree. Putting your savings in a bank account? You're gambling that the interest rate will be higher than inflation and also higher than the risk-adjusted returns in any other investment type. Buying a house instead of renting? You're gambling that it'll be cheaper and more convenient than renting, after capital costs and price changes. Renting instead of buying? The opposite. Any choice you make, including not making any choice, has consequences.

Putting your money in the stock market? You're gambling that the risk-adjusted returns from the stock market is higher than that of a bank account. Performing stock or option trading according to some strategy? You're betting that you're smarter than your counterparties. Trading any type of paper you don't understand? That's more akin to playing the lotto.

It's a continuum.

Can I just say that this is an incredibly good comment?

Seriously, between the finite time that one has to live and the decisions you have to make everyday, I think any notion of "satbility" is at best, an illusion. Only change is constant.

Thank you :)

Basic option strategies: the TLDR; guide:

If you are buying options - you will consistently lose money. Both time and risk premia overpricing go against you. If you don't make the mark within the time period (and market dynamics are notoriously hard to predict) - you will lose 100%. Breaking even often requires a large 5-7% move in your favour - and that just doesn't happen often enough - especially in the one month buy-to-mark time frame that most options trade at. Nassim Taleb does this - he probably makes more money selling pretty books and giving fancy talks.

If you are selling options - you will consistently make fat stacks until you blow up (since you're the counterparty of the above buyers). You can push naked index puts or calls all you want, and make an absolute fucking killing. I'm not kidding. You could easily pull $10-200K a month in profit, depending on how much of a baller you think you are, and how much capital you have backing your risk-taking ass (talking individual traders here).

But this money isn't without insane risks, have no doubt - you are playing with an armed thermonuclear warhead. If all the market correlations go to one and you're the last guy holding the bag containing other people's vol - you will get decimated. LTCM did this for 3 years - blew up year 4 - lost $5 billion in one month. LTCM principals went on and started a bunch of similar firms - finance is apparently very forgiving of failure - it shouldn't be. Most of those funds went thermonuclear back during the 2007 GFC.

If you do a mixed strategy - you'll end up with mixed results - because you're just mixing the above. No option strategy outside of market making consistently makes money (computational traders making markets and taking hedged spreads).

It's exactly like insurance. Insurance buyers pay up, but they never want to actually use it (unless they are committing fraud/market manipulation), and are happy to burn that cash to protect themselves. Insurance sellers are happy to sell, but their industry is commodity, and the only way they make money is by investing the float they have on hand between cash inflows (buyer premiums today) and cash outflows (buyers claiming a year later).

Problem is shares aren't like physical goods - they aren't bound by physical laws and hence do not follow the normal distribution. Share prices can go to infinity and hit zero all over the course of a day - their just bits of data in a db somewhere in Jersey. Car crashes, geographically separated houses and diversified mega-cat risk don't do that - often :D.

If you put in a costless collar on a stock you already own, you cap both your upside and your downside relatively cheaply (this is how Mark Cuban survived the dot-com crash with $2 billion in Yahoo! stock).

Outside of those few lessons - unless you are pushing statistical liquidity or selling millions of options per day - stay the fuck away from them. Individual investors should either go passive index or if they know an industry inside and out value-growth.

Everybody else should either be supply liquidity (HFT - not too profitable anymore) or pushing relative stat arb (RenTech/Shaw's + hundreds of PhDs). Individuals should not try to compete in this area - at all. Just like you don't try to build your own car, cruise ship, 747, iPhone or tank, you shouldn't try and trade against stat. arb/HFT guys without the mental or financial backing to hold your own shit.

Value-growth/passive works because the market comes to you - hat in hand saying - here take my money please. Stat. arb/HFT also works, but it's much harder, because you have to go to the market and make sure that it isn't you that is saying - here take my money, please.

This is a good post with things to think about. The key variables of option pricing--but in particular Vol--are not understood by most people. The second order effects people fail to grasp. A simple, classic example: volatility smile.

The <valuation> of an option is <in general> distinct from "payout" and not simple linear math. [1]

________

[1] http://en.wikipedia.org/wiki/Black%E2%80%93Scholes

Consider: You can't lose money just by owning an option

This is clearly a problematic statement. etc.

The statement's point is pedagogical - you don't risk more by buying an option than you pay up front. It's also true - if someone were to offer you free options, you couldn't lose money by accepting them.

This is distinctly different from, say, a future or a forward, which is an agreement with no money exchanged upfront (other than commissions and margin requirements).

To be fair, if you can sanely use options on the buy-side (as insurance or call income, as opposed to buying lottery tickets) you can also sanely use them on the sell-side too. The problem is, you need deep pockets to do so on the sell side, since you need to be able to buy the stock without breaking a sweat. Specifically, the sane way to use options on the sell side is to use them as a way to commit to a price you believe is (or technically, will be) fair, regardless of what the market says on the matter at that time. (Yes, this presumes you believe EMH is bullshit.) If they expire, you make a decent income. If you're assigned, you're content purchasing the stock at that price, regardless of the market price. (Or, if you're not due to some underlying change in the fundamentals, you can occasionally roll the contract forward. You should have probably done this before assignment day otherwise you are fooling yourself.)

Of course this leads back to your main point being unchanged: only experts are going to have confidence in knowing what a "fair" price is for a business, so selling options (or using them in general) should be left to such experts.

The problem with people, markets and efficiency: They see markets and go - wow - that's pretty fucking good, my prices just went down, I got better service and it's harder for others to make money now so things must be priced competitively.

Problem is they go to far. As soon as they state that you can't make money in markets - they've just crossed into stupid territory. If that were true - the world would be efficient and no one would ever make any money, because everything would be priced correctly.

What is with people separating stocks from businesses. If you work at a business, you are by definition stating that the market you work in is not efficient and hence EMH is bullshit. It's like massive cognitive dissonance - stocks are completely separate in people's minds from the shit that actually gets done - it's insane. It's just like religion. I mean you can happily see someone flying in a plane and the next second they'll be telling you how god exists and how science is bad. YOUR IN A FUCKING PLANE! Your life depends on science and engineering and they state that you are wrong.

Markets are what I'd call "better than central" planning efficient. They are better than central planning - for example you are a young programmer - how will a government bureaucrat know that you should go start an app company - it's better if people figure out what to do themselves, because they know themselves the best and can on average pick careers more correctly than a "sorting hat". But they are still pretty crappy because people make shitty choices all the time.

I agree with all your points - sell-side is a great money maker for people who know their shit. Buffett is one example. He runs $60 billion in insurance float, with nearly $24 running reinsurance and mega-cat risk. He makes a lot of money. But unless you have the financial reserves to back up your claims - don't even bother.

Buy insurance if you wish to hedge yourself - otherwise - stay the hell away.

Yeah it's all about how much capital you have. People selling "cheap" options whose underlyings are worth 10x more than their entire net worth are playing with fire. Options should always be bought or sold as a proxy for the underlying, not thought of as standalone priced securities, IMHO. I think this is the mental trap that most people fall into when they get screwed by options -- they are seen as just another symbol on their trading platform with a price they can buy and sell. However, they have wildly different dynamics since they are, literally, derivatives.

Hi, could I get some way to contact you to discuss trading strategies

Do yourself a favor and don't. From his post I would assume he has been burnt by options in the past and may not have the best insight into them or the possibilities they open up.

Why would I discuss profitable trading strategies?

That would be pretty stupid. I'd only discuss losing ones.

Like, for example, options.

Also a good rule to live your life by - if someone is trying to sell you some strategy don't bother.

Hi there. I buy options all the time. I make lots of money doing it. You only need a 1 to 2% change in price to make decent money when working with options[1]. I don't know why you quote 5-7% as that's just not true. Even if it was Stocks regularly move by that amount on a weekly basis. I know it may not be much to some, but I made over 50k doing one or two options purchases per month last year ( 2011, 25k base investment). I had to stop this year due to me needing to liquidate my portfolio to free up some cash, but what your saying is verifiably false.

1. As of 13 November 2012 GOOG dropped by ~1% a $650 put options rose in price by $1.70 had you owned just one contract you would have made $170 your outlay for that would have been $1180 a one day gain of ~15% even subtracting the trading fee of $10.00 to buy and $10.00 to sell you made $150 for a $1180 outlay or 12% in one day on one stock. This particular transaction is very risky as there is no hedge against a decrease in the put price. You can do that, but it will take more time to explain then I have right now. My napkin math tells me you could have placed a less risky trade and make a cool $100 on a 1% change with a 1K investment (i.e. 10%) on one day with minimal risk (risk is if stock isn't volatile enough or trailing stops are set wrong) .

> a cool $100 on a 1% change with a 1K investment

Don't lie - the vast majority of options expire worthless. Your argument is like saying: "Oh if you buy that piece of shit penny stock and it goes up 1 penny - you'll double your money - no cash down!". Sounds an awful lot like a scam to me.

There are no free lunches. Anyone who say's otherwise - is lying.

expiring doesn't have a thing to do with it. I bought and sold the security on the same day. Also most don't expire worthless, about half expire worthless the other half expire with marketable value

Factor in time decay and rapidly falling risk value and you'll see my point about being worthless. The intrinsic value of options is almost always an order of magnitude less than what you pay for it (at the money - most liquid). Being worth 10% what you pay for something is not marketable value.

Verifiably false. Look at the November 17th $600 Call option for GOOG today. Its selling for $59.40 it has an intrinsic value of 59.05 and a time value of $0.35. In this case the time value is two orders of magnitude _less_ then the intrinsic value. That's just one example to prove my point. Your whole concept of options is bad, and you should feel bad

I said at the money not deep in the money genius. That call is almost a stock. Most options are traded at the money and most of the money is made there too. My statement is true.

So if you buy a option that by definition has _only_ time value, then by definition it will have very little intrinsic value. However contrary to your assertion most options are not traded there As of today (14 November 2012) on GOOG the at the money had the highest number of contracts traded at it ( ~350 at 660 ), but the total number of GOOG contracts traded was ~1100 so at the money was not even half of the contracts traded. I will leave these two links here one is to the google finance page so you can have a clue about what your trying to debate the second is to the definition of majority since you don't seem to know it

1.http://www.google.com/finance/option_chain?q=NASDAQ:GOOG&... 2. http://www.merriam-webster.com/dictionary/majority

You're playing with nuclear weapons. If you stand to make $10K profit, you're exposing yourself to a much more massive downside.

Being extremely careful will only prolong the inevitable crunch. You're betting on a 1% hike that might be a 5% drop because some idiot in a bus ran over someone important. That 5% drop could clean you out.

If you're betting on sure things, which means you're cheating somehow, then options are your best bet. Hey, if it works for you, you've got a good racket going, but most people will be absolutely destroyed.

Here is the quick and dirty recipe for making money off volatility.

Buy a put and a call option for the same strike price. On both options place a trailing stop at a fixed point ( <- that's where skill / statistical analysis comes in ) After one of those two orders execute cancel the second order and place a new trailing stop at a lower value to prevent additional loss.

If the stock goes up you sell the put and ride the call until the price drops or you liquidate.

If the stock falls you sell the call and ride the put.

Your risk is total to the loss in time value of the option for the duration of your trade , and is capped at a maximum of the sum total of the two trailing limits on your initial purchase. If you would like me to run the numbers for it please give me a security and I can even tell you where to set your puts ( I have computer programs I use to calculate reasonable stops , and execute this particular strategy )

So basically you can lose everything you put in. This is a slot-machine strategy. It's a load of crap.

Anything bought on margin or of a derivative nature is like this. You can bust out hard.

The thing with buying an actual security is a 5% drop is only a 5% drop in value, whereas in an option a 5% drop could translate to a gigantic liability.

trailing stops limit your risk to a percentage of your initial investment. Its the same thing as with purchasing a stock. That investment can also lose all its value overnight. Its less likely to happen ( less risk ) and its also less likely to really increase much ( less reward ). All options do is scale up the risk/reward.

It's extremely rare that a security loses all of its value in a short period of time. In the last twenty years I can think of only a few occasions where it's happened that quickly, and it's almost always front-page news.

Options, on the other hand, are constantly declining to zero value. It's how they work. If you end up out of the money at the end of the day, you bust out on that bet.

Nobody is arguing about the long side of options being "oh god run for the hills nuclear weapons dangerous", they are arguing that about the short side (or certain complicated strategies that are long-short.) The long side is just a suckers bet, but it's a relatively low risk one. You buy a $1000 call -- most of the time you lose the $1000. Sometimes you break even. Rarely you make a little money. Once in a blue moon you 2 or 3x your money. (These are the instances you remember and hence you keep buying calls.) In the long run, you lose money (academic studies have shown this.)

Where you can really get screwed is going (naked) short. Lets say you shorted a "modest" $1000 worth of out-of-the-money GOOG options today with a 8% spread from strike. The $600 Dec 22nd puts right now cost $2.80, so you'd sell 4 contracts for $1120. 8% is plenty of cushion, right? As long as GOOG's price doesn't go down more than 8% before expiration, you'd have $1120 in your pocket. That's a huge drop and highly unlikely. An easy $1120, right? It worked last month and the month before, so why not this time?

But oops, lets say just like last time GOOG's earnings leak early because someone fat fingered an email or something, and the stock took an instant 12% haircut. That extra 4% below your strike price just cost you approximately $24 per share. You had 4 contracts, so your options were against 400 shares. You just lost $24 * 400 shares = $9600 in order to make an "easy" $1,120.

Now, consider the fact that many people are going to be looking to make more than $1,000 a month when trading options. More like $5,000-$10,000. Guess what -- if the market systematically crashes by 10% over a few days because Ben Bernanke sneezed during a speech you could be in the hole for hundreds of thousands of dollars depending on what positions you've taken.

Also, if you were to buy closer to-the-expiration options (say, ones expiring next week as opposed to next month), the per-contract costs go down by approx a factor of 10, so you have to sell 10x more contracts in order to get the same gain. But guess what, if your luck is particularly bad and something goes horribly wrong, you can multiply your losses above by a factor of 10. (Yes, Virginia, with options it is possible, nay, easy to have a 10,000% loss in a few minutes on a bad day.)

That's how you can get fucked. You keep selling short puts on positions you can't really cover comfortably, and rake in the dough. And then on one sunny otherwise uneventful autumn afternoon something weird happens, and Vegas, er, I mean, Wall Street, takes it all back, and much more.

Great comment gfodor. I like to think of it like this.

Buying options is like gambling at a casino. Statistically you will just keep losing money because the house always wins - they have the edge - unless you play a game like poker with a bunch of suckers - where the casino still takes a nice chunk of your change.

Selling options is like being a casino without the ability to know what the statistics of the underlying distributions or their payoffs are. Nor do you have the ability to kick a guy out if he wins too big and too often. It's a casino without the control. And a casino without control - is a casino that goes bankrupt.

So your saying if you don't manage your risk you will lost a lot of money ? Thats goes without saying which is why its called risk. The purchase I talked about exposed me to my purchase price in risk. In reality the risk was less since _everyone_ for every stock purchase should always set trailing stops to limit risk. In my theoretical trade of purchasing a put option on GOOG you are exposed to a maximum of you outlay in risk ( no ballooning risk ) and if like you should you set a trailing stop you further limit your risk to a small subset of the initial outlay.

Also to further prove that your wrong. The SEC has rules in place requiring that investors are not allowed to have to mush risk in their portfolio. Had you done what you jsut claimed and did a naked short on GOOG with no protection you would have been required to either pony up a large cash reserve ( protecting your broker from the liability ). Most responsible brokerages won't even allow your trade to go through unless again you have a large enough portfolio to absorb any reasonable risk.

This by the way is only using options for speculation. They have lots of other useful purposes and you haven't even discussed things like covered calls and using options as insurgence against volatility.

It doesn't seem that your read my comment since my entire point is that you seem to be acting like the buy-side of options is the 'nuclear weapons' the OP is warning people about. The buy side of options is perfectly "safe" since it is only really leveraged on the upside. It's the sell side that is a concern and requires extreme caution since it is leveraged on the downside. I'm not sure what you are claiming I am "wrong" about since nothing I said in my previous post was an opinion but simply explaining facts around the risk factors involved to make sure readers of this thread don't mix up the buy side and sell side of options and their associated risks.

You can get naked put option permission at many brokerages once you have done some trading. Also your point about stops is irrelevant: the way you get burned by short options isn't from a stock price slowly grazing down past your stop, it's when the value of the company objectively changes by 5-10% overnight or instantly intra-day due to some event or disclosure. The rarity of this situation is the very reason that the risk in short options is easy to ignore since you are selling insurance against tail risks and usually don't have to pay up to the buyer. (Covered calls can be viewed as 'income for the price of potential gains' or 'insurance for short sellers' depending on how you want to view it. The same argument applies on both types of options.)

TLDR; "Individual investors should either go passive index or if they know an industry inside and out value-growth."

Hey, I just distilled 2 years worth of option experience and a decade of trading experience into a few paragraphs - give me a break :).

But yeh - that's what normal people should do.

Haha, yea that's actually was one of the most concise and accurate summaries of options I've seen, though unlike the OP, some of the terminology would be lost on a layman.

I like what these guys are doing, and we tried out their plugin for modelling.

However, you can't really do any modelling without factoring transaction costs. For the average retail investor these fees kill the profit on many otherwise theoretically profitable strategies.

I'm interested in an in-depth tutorial that shows how to use the plugin to perform this kind of analysis. While I don't work in trading, I can see a lot of good uses for a tool like this while conducting other financial analysis.

Send me an email, we'll talk - ben@datanitro.com

Do brokers typically exercise your options for you automatically at the end of the term or do you lose all the money if you forget?

They'll usually either be exercised or settled for cash if they're profitable. You should look into your broker's policy, though - if they're exercised, you should be sure you have enough capital to cover the position.

You should also not be in a position to forget about your options - they can move very quickly and forgetting about the position can cost a lot of money.

Gr8 intro article. Couple of tips.

You can buy stock and sell out of the money calls against them, thus reducing the overall purchase price. The stock can be called away if it rises above the strike price thereby capping the profits. However, you can always roll the options when you near the strike price and expiration. That way, you don't loose the stock when its having a great run. This also works in the specific case of sitting on FB stock from day one and being in a big hole at the moment. Keep selling out of the money calls and having them expire worthless, but keep rolling them to the next month when they get close to expiration.

I'm shocked to see Options being mentioned on hackernews. Though, I have been doing options for the past 6 months. Previously I had never even heard of them and knew nothing. Here are some insights as to what to expect...

Options are not for the faint of heart. If you are brand new to options and are just starting out then I suggest having a friend/expert help you. I also suggest you use very little money at first to get a feel for it. (Less than $300 at a time). Otherwise you will lose money, and quickly.

The only way you'll get good at options strategy is to practice them. There are no shortcuts to success (aside from getting lucky). You will likely lose money at first, unless you have a good teacher to hold your hand.

There are a lot of little nuances and safer ways to make money with options that I've slowly discovered over the past few months. Earnings are an exciting time. One could safely make several thousand each quarter if they are smart. I am just getting the hang of it after 2 quarters.

I personally stick to tech stocks like apple, google, and facebook. I usually only do weekly options. Ideally, you want to dabble in stocks that move as much as possible. (For example, if you had Apple PUTS this past week, you would have made a killing. This is true for Straddles or Strangles).

After dabbling in options for 6 months I would say that the average person should avoid them at all costs. You really can lose a lot of money and sleep. You need to be a certain type of person to do this as a hobby.

For those of you willing to take the risk, best of luck to you. With options, you are better to be lucky than good. It is true that you can make a lot of money if you are smart and patient. However, you will lose a lot of sleep either way.

You don't mention the downside of buying options... If it goes up, but doesn't hit the strike, you lose all your money. Options are a pretty risky play and it's typically not recommended that your average investor play the options market.

From the article:

> There are lots of ways to combine options for different stock outlooks. Here are some common ones, not accounting for option cost.

He does mention it, but it's not very prominent. I also agree that not including the cost of opening the position in the payoff chart is misleading (and unconventional).

The author mentioned this risk in the second paragraph:

> ... in fact, you can lose everything even if the stock goes up, but not by enough.

I was wondering if a straddle on GRPN would make sense?

A straddle is a way to trade volatility, so this makes sense if you think the stock's volatility is higher than the market thinks it is. (In other words, you'll make money if the stock will move more than the market thinks it's going to move.)

But only if you buy enough contracts to cover your costs. One of the big hiccups in straddles is that the stock has to move far enough to cover your costs, plus a bit.

It's very easy to make small amounts of money on options, but you can probably put that time into a minimum wage job and make more.

Is anyone reputable selling options on bitcoins? I'd like to bet on high volatility there...

I can sell you bitcoin options...but they'll probably be more expensive than you want :P

Are you reputable? :-P

On a regular trading day (ie no earnings report, no news expected), trading straddles for a short term gain does not make sense to me. The stock has to move more than the price of the 2 legs + commission for you to break even. Feel free to trade straddles on GRPN, FIO, QCOM, AAPL, GOOG, PCLN and other stocks with a history of wild post earning swings. You might get very lucky.

You can set trailing stops on a straddle to make it more profitable.

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