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Know Your Options: Three Secrets Every Trader Should Know

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“Progress always involves risk. You can’t steal second base and keep your foot on first.” – Frederick B. Wilcox

The world of option trading is a fast-paced and exciting one. It can also be extremely lucrative provided that traders understand the risks involved. Options contain inherent leverage that make them riskier than owning individual stocks and ETFs, but as traders, it’s our job to identify those risks and put the odds back in our favor.

We are in the business of prudent speculation. We must manage risk as best we can while employing a powerful approach that produces consistent profits. Sounds easy, right?

Of course, trading options successfully is far from easy. Many options traders fail because they attempt to predict the future, and as most options expire worthless, it’s not difficult to see why they have a low rate of success.

Fortunately, there are methods you can start using today to reverse conventional wisdom and stack the deck in your favor. Let’s review three secrets that every options trader can benefit from.

Secret #1: Use an Online Discount Broker

Over the past few years, trading commissions have drastically decreased – including those for options. Discount brokers have been competing forcefully with one another, and all this competition has driven down rates. Individuals can now trade stocks for free in most cases, and options contracts cost just pennies on the dollar.

With today’s investment landscape relying heavily on mobile applications, digital technology and the internet, many investors are opting to buy and sell securities for themselves rather than pay advisors larger commissions to execute trades. These low commissions have reduced investment costs to the point where they are almost insignificant.

While there will likely always be a need for full-service brokers (as they do provide a valuable service for investors who need more guidance), the trend is clearly moving away from this method.

There’s no shortage of options for discount brokers; traders should do their homework and decide which firm is best for their individual situation.

Secret #2: Reduce the Hidden Costs of Trading Options

There is always another party on the other side of every trade. Similar to when we buy and sell stocks, transacting in options involves dealing with a “market maker” on the other side. For example, when we purchase a call option, the market maker is selling us that same option.

Options are generally not as liquid as stocks, and therefore the market maker attempts to realize a profit from the bid/ask spread. This spread is typically much wider for options as opposed to stocks. This makes it more difficult to trade options, particularly those with low volumes. It also allows the market maker to be compensated for taking on the risk of the other side of the transaction.

One way we can alleviate this problem is with the use of limit orders. A limit order is a trade order to purchase or sell a security at a specified price or better. In effect, this order specifies the highest price we are willing to pay to buy and the lowest price we are willing to accept to sell a given security.

Let’s take a look at an example. Amazon stock (AMZN - Free Report) currently meets our criteria for a call option purchase. We can see below that the AMZN August 16 160-strike call has a bid quote of 41.6 points and an ask of 42 points. As options cover 100 shares of the underlying security, the current asking price for interested buyers is $4,200 per contract, while the bid price for interested sellers is $4,160.

Chicago Board Options Exchange

Chicago Board Options Exchange
Image Source: Chicago Board Options Exchange

If you were to use a market order to purchase this call option, we’d expect to be filled at the ask price. But we can use limit orders to discover the best price that a market maker is willing to sell us this option. I’ve often found that we can get filled at the midpoint between the bid and ask, saving us $20 for a total of $4,180 in this example.

Finding a market maker that is able to buy or sell at a more favorable price can result in significant cost savings over time. In this example, the bid/ask spread wasn’t very wide, but keep in mind that these savings can become much more substantial when dealing with underlying stocks (and their associated options) that aren’t as liquid as Amazon.

Secret #3: Quantify the Risk/Reward of Every Trade Beforehand

Amazon is a Zacks Rank #2 (Buy) at the time of this writing and is in a price uptrend, making it a good candidate for a call option purchase. When done correctly, trading options provides huge profit opportunities with limited risk.

Resuming our example, we’re going to target the AMZN August 16160-strike call. This option has an expiration date of August 16th, which is about a month and a half away. Purchasing this option gives us the right, but not the obligation, to buy 100 shares of Amazon stock at $160 on or before the expiration date.

The table below displays the risk/reward profile for this trade. Amazon is currently trading at $200/share (orange box). We are purchasing 1 August 16 160-strike call at 41.8 points, which is the option premium. Since options account for 100 shares of the underlying stock, the total cost for this call option trade is $4,180 as we can see in the yellow highlighted box.

Zacks Investment Research
Image Source: Zacks Investment Research

The top (blue) row shows the performance of AMZN stock based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our call option trade. We can see that if AMZN remains flat, this trade would encounter a minor loss of 4.3%. If AMZN moves up 5%, this trade will realize a 19.6% profit. If AMZN advances 15%, we would realize a 67.5% profit.

This illustration shows the inherent leverage that options provide. A stock investor who bought 100 shares of Amazon would have to contribute $20,000, which is a much bigger investment. A 15% increase in the stock price would yield a $3,000 profit.

On the other hand, in this example the option trader only needs to contribute $4,180 to control the same amount of underlying AMZN shares. A 15% move in AMZN stock would net a $2,820 profit – a nearly identical profit amount with only about one-fifth of the investment!

Also note that this option contains relatively little time value. The 1.8 points worth of time value (red box) equate to just 0.9% of the Amazon stock price. A good way to manage risk when buying call options is to minimize time value and maximize intrinsic value, as time value decays rapidly in the days leading up to option expiration.

By managing the risk/reward relationship and using the methods discussed to reduce the costs of options trading, we can effectively put the odds back into our favor.

Disclosure: The author may hold a position in the security mentioned.

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