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How to Make Money Trading Stock Options

Posted on February 11, 2009 by Adam

Welcome traders!

This is the second part in a series of several articles introducing basic options theory. You can read about what options are and how they are priced here. This article will focus on option trading strategy, and how you can use them to increase your profits. I’ll go into the specifics of how puts and calls are priced and how to select the best option for your trade.

Option Pricing Guidelines

• Calls increase in value as the stock goes up
• Puts increase in value as the stock goes down
• Intrinsic value = |Stock Price – Strike Price|
• Extrinsic value = Option Premium – Intrinsic value
• Extrinsic value is also known as time value, since it is priced into the option to account for moves the underlying may make into the future.

Let’s take a break to discuss the above points…

Since calls give you the right to buy the stock at the strike price, the higher the price goes, the more of a discount you get on the stock as a benefit of owning the option. Since strike price is fixed – it remains constant at all times – when the stock price increases, the intrinsic value of the option increases.

Here’s an example:

RIMM is trading at 50 and I buy a March 45 call option for $6.50. Since a stock option controls 100 shares, the total cost of my trade minus commissions will be $650. The intrinsic value here is:

(Stock Price $50) – (Strike Price $45) = (Intrinsic Value $5)

To get extrinsic, or time value, we subtract the intrinsic value from the option premium:

(Option Premium $6.50) – (Intrinsic Value $5) = (Time Value $1.50)

If the stock moves up to $55 before the end of March, a 10% move, the time value will remain relatively unchanged, but the intrinsic value will increase by $5.00, bringing the total option premium to $11.50, a 77% move.

This discrepancy in percentage moves is known as leverage, and is one of the major advantages in trading options over the stock, in addition to it being much cheaper!

Most brokers will calculate intrinsic and extrinsic value for you, but you should have a good idea of how it is calculated, because it becomes important when it comes to option selection.

• Some options give more leverage than others, depending on the ratio of intrinsic value to option premium. This ratio contributes to what is known as delta. The higher the delta, the more your option will move as the stock price changes.
• 0 < Delta < 1
• If the stock moves by one dollar, you can expect the option premium to change by delta dollars
• In the money options are options where the strike price is below the stock price (for calls), and where the strike price is above the stock price (for puts). If you exercised an in the money option, you would get a discount.
• At the money options are where the strike price is very close to the stock price. If you exercised an at the money option, you would get a very small discount, if any.
• Out of the money options are where the stock price is above the strike price (for calls), and where the stock price is below the strike price (for puts). In essence, the option is useless for a discount, unless the stock makes a big move in your favor.
• In the money options have high delta, since their premiums are mostly made up of intrinsic value. At the money options have delta near 0.50, since their premiums are made up of some intrinsic and some time value. Out of the money options have very low delta, since their premium is entirely made of time value (intrinsic value is nil).

Let’s take another discussion break. The higher the delta, the more leverage the option provides, since the change in option premium is delta times the stock price movement:

(Option Premium Movement, $5) = (Delta, 0.8) * (Stock Price Movement, $6.25)

Since in the money option premiums are made up mostly of intrinsic value, they have high delta, probably close to 1.

Since at the money option premiums are made up of some intrinsic and some extrinsic value, they have a delta near .5

Since out of the money option premiums are made up entirely of extrinsic value, they have very low deltas, usually around 0.2.

Let’s use our previous example to illustrate:

When RIMM is trading at 50, buying a 45 call would be in the money, so we would expect it to have a high delta. It’s actually pretty near the money though, so it might have a delta of about 0.6 in reality.

Had we bought a 60 call, we would have an out of the money option. Its delta would be much lower, probably close to 0.3. As a result, the profits we would see from selecting this option would be substantially lower.

Had we gone deeper in the money, say to a 40, then our delta would be higher, and our returns would have been larger.

We have still yet to discuss what affects time value…

• Time value decreases as the option approaches expiration
• If an option expires without any intrinsic value, it will be worth nothing
• This wasting process is known as time decay
• Out of the money options are more affected by time decay than are in the money options, since they are entirely time value.
• Each day that passes is less time for the stock to make the move, and each day time value erodes.
• Be careful when trading front month options (options that expire this month), especially when they are out of the money. Make sure you leave enough time for the stock to move in your direction.
• Extrinsic value increases when traders are expecting a big move out of the underlying, and decreases when expectations fade.
• Be careful when buying large amounts of time value for all these reasons.

Finally, let’s talk about placing a simple option trade…

Say I am expecting a big move in a stock because I spot some technical setup… say, PNC?

In this setup, I identified what would likely be a big breakdown beneath $42.50. I figured I had enough time to go with February options, given that I had about 25 days until expiration, and I didn’t think it would be too long before the move happened.

I looked at the option chain and decided which option to pick. I was bearish, so I went with a put option. I decided to go one strike in the money, with a 45 put, which had a delta near ~60. A more conservative bet would have been the 50’s, but I didn’t want to tie up too much margin in the trade, as 60’s would have been more expensive. Besides, 45’s gave me enough room for my risk tolerance. I think I paid about $3 per contract.

I always use limit orders when buying options, since the premium is so small and spreads are usually a fair percentage of that price tag. I usually start with an order placed at the mid and move it up to the ask if the market maker doesn’t want to fill me at the mid.

Nice Trade!

You can see from the chart what happened. I sold my puts two days later with almost a 600% profit. One of my best trades ever. Money!

Here are some final guidelines for option selection:

• Only trade liquid options – look for open interest of at least 1000 and spreads to be no more than 5% of the contract premium
• Don’t go selling options unless you know what you’re doing. Stick to option buying until you’re an expert.
• Be careful with out of the money options – it’s an extremely aggressive trade
• PLEASE MANAGE RISK. Options supersize your losses too, unless you’re careful. As long as you’re an option buyer, you can only lose what you pay, but still, know when to exit the trade when you are wrong. I don’t want any of you to blow up your accounts because of something silly like that.
• Don’t add to a losing option position – just take my word for it. If you’re that far down, just exit the trade and walk away.

If you think this article was helpful, you may want to bookmark it to keep as a reference. I’ve also added a page with an options cheat sheet, with lots of tidbits to help you. I’ll fill it out with more content as we progress with this series on options every Monday night.

Until next time,

Happy Trading!