Don’t Buy Another Option Until You Read This

By TradeSmith Editorial Staff

Welcome back to another edition of Money Talks!

For the last month or so, we’ve been talking about one of the most misunderstood — yet potentially lucrative — assets in the investment world: options.

We spent several weeks covering the basics to (hopefully) clear up any confusion you had about the risks and benefits of trading options. And last time, we took a detailed look at one of the safest options trades you can make: selling covered calls.

Today, we’re going to take a look at long options trades, which include both “Buy Calls” trades and “Buy Puts” trades.

Now, long options trades are generally the easiest type of options trade to understand. And unlike short options trades like selling puts, they have strictly limited downside risk. When you buy a call or a put, you know exactly how much you can lose in a worst-case scenario.

Because of this combination, long options trades tend to be popular among novice traders.

But what many of these folks don’t understand is that this defined-risk profile comes with a big trade-off: a much lower probability of profit (POP).

That is primarily due to two factors.

First, options contracts lose value over time, and this loss of value — known as time decay — speeds up as the option moves closer to its expiration date. Time decay works in your favor when selling an option, but it’s a disadvantage when buying one.

Second, in long options trades, you must pay to buy the option. That should be obvious, but as I’ll show you in the examples below, this can act as an additional hurdle to profitability.

As a result, the best long options trades rarely have much more than a 60% chance of earning a profit. Most are no better than a coin flip. That means you should only trade long options with money you can afford to lose.

Unfortunately, many folks don’t understand the odds are against them in these trades, and they commit more money than they should.

They might have some success initially; they might even hit it big on one or two trades.

But if they continue to risk more than they can afford to lose, sooner or later, they’re sure to suffer a string of losses that can wipe out a massive part of their portfolio.

It happens all the time, but I don’t want it to happen to you. So please, if you’re going to buy options, be conservative and don’t risk the rent money.

OK, now that we’ve gotten that out of the way, let’s look at how these trades work in practice.

We’ll start with long put trades (buy puts).

Buy Puts

As I’ve explained, when you buy a put option, you’re essentially betting that the price of an underlying stock will go down.

There are two primary types of long put trades: protective puts and standard long puts.

A protective put is simply a put option trade on a stock you own. Like a covered call trade, in a protective put trade, you would buy one put option for every 100 shares of the underlying stock you own.

This trade is like insurance on your stock position. It gives you the right to sell your shares at the strike price, no matter what happens to the stock’s actual price.

For example, let’s assume we own 100 shares of Apple (AAPL). The stock is currently trading around $145 — up more than 100% since it triggered a TradeSmith Entry Signal in April 2020 — and we think it might be due for a significant pullback over the next month or two.

Rather than take profits today, we decide to buy a protective put option. We buy one AAPL $140 put expiring Sept. 17, 2021, for around $260 ($2.60 per underlying share).

Here’s how the trade can play out.

If we’re wrong and Apple keeps moving higher — or falls just a little — and closes at or above $140 on Sept. 17, our “insurance” will expire worthless. We’ll lose our bet, but we’ll still own our AAPL shares and can benefit from any additional upside.

We could also sell the contract to close the trade before expiration. However, because of the time decay I mentioned earlier, we may not be able to recoup much of our investment by doing so.

If we’re right and AAPL trades below $140 by Sept. 17, we can choose to sell our shares for $140.

No matter how far AAPL falls below $140, we can’t lose more than $760, or $7.60 per share. That’s a maximum of $5 per share ($145 minus the $140 strike price) plus the $2.60 per share we paid for the option.

In this case, closing the trade before expiration would result in a similar maximum loss while allowing us to continue to hold shares.

For example, if AAPL fell to $135, we would be holding an unrealized loss of $1,000 ($10 per share) from today’s value. But our put option would be worth at least $500 ($5 per share).

If we sold the option before expiration, we could reduce our unrealized loss to no more than $500 ($5 per share). Add that to the $260 ($2.60 per share) we paid to buy the option, and our net loss would be that same $760 ($7.60 per share).. But again, we’d still own our original 100 shares of AAPL.

Standard long puts also give you the right to sell shares of an underlying stock at a specific strike price. But because you don’t have to own the underlying shares, these trades are typically used to speculate on lower prices.

Long put trades work similarly to protective puts. But because your goal is to profit — rather than just reduce your risk in an existing position — the potential outcomes are a bit different.

Let’s look at a long put trade using that same AAPL option to show you what I mean.

Again, we’ll buy the AAPL $140 put expiring Sept. 17, 2021, for around $260. But in this case, we don’t own any Apple shares. Instead, we’re making a direct bet that AAPL will fall significantly below $140 by Sept. 17.

Here’s how this trade can play out.

Like before, if we’re wrong and Apple keeps moving higher — or falls just a little — and closes at or above $140 on Sept. 17, the option will expire worthless. We’ll lose our bet and the premium we paid for the put contract.

However, if AAPL closes below $140 but above $137.40, we’ll still lose money on the trade even though the option itself is “in the money.” That’s because we paid $2.60 per share for the option.

To earn a profit from the trade, we would need AAPL to trade below $137.40 by Sept. 17. And the further below $137.40 it falls, the more money we would make.

Buy Calls

When you buy a call option, you’re betting that the price of an underlying stock will go up rather than down.

But long call trades otherwise work the same as the long put trades we just reviewed.

For example, suppose we have a change of heart and decide AAPL shares will move even higher over the next couple of months.

Rather than buy a full position in the stock, we could buy the AAPL $150 call option expiring on Sept. 17, 2021, for around $300 ($3.00 per underlying share).

Here’s how this trade can play out.

If Apple closes at or below $150 on Sept. 17, our option will expire worthless. We’ll lose our bet and the premium we paid for the call contract.

If Apple closes between $150 and $153, the option will expire “in the money.” But it will be worth less than the $3.00 per share we paid for it. We’ll still lose our bet.

To earn a profit from this trade, we need AAPL to trade above $153 before expiration.

That’s it for today. Next time I’ll walk you through my favorite type of options trade: selling puts.

In the meantime, if you have any questions or comments about what we’ve covered so far, I welcome your feedback. As always, you can reach me directly at [email protected].