This Tricky Financial Tool is Well Worth Learning
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There’s an old saying that’s useful to remember, but also kind of a bitter pill to swallow:
“If it’s hard to do, it’s likely worth doing.”
This advice applies to all kinds of fulfilling things in life. Playing competitive sports, saving money for a financial goal, learning a new technical skill, speaking a foreign language, and tons more examples float to the top of my mind.
The best rewards often come from the trickiest of pursuits.
And in the world of finance, look no further than the multimillionaire, even multi-billionaire hedge fund traders for the best example.
Top traders earn so much wealth, so quickly, because they trade with advanced methods that go far beyond buying and selling stocks.
One big technique the big boys use is leverage.
Leverage lets traders take otherwise small moves in assets and turn them into much bigger, more profitable moves. Usually by borrowing money (aka margin) and posting assets as collateral.
Knowing how to manage the risks leverage brings – maybe one of the hardest pursuits in the financial world – is what separates the ultra-wealthy from the rest of the pack.
Now, I wouldn’t recommend margin trading for most people.
But most people have access to a similar, though safer kind of leverage in their brokerage accounts: options.
Options trading is an essential tool for any investor’s kit. Though, I wouldn’t call it easy to learn.
If learning how to snowboard, or speak Mandarin, or program a computer has a learning curve… trading options effectively may as well have a learning wall. Especially considering the financial component, you can go bust very quickly if you make the wrong move.
Still, options trading is a huge part of my financial discipline and I’m far wealthier because of it.
And when used well, options can accelerate your wealth and mitigate your risk.
We believe in the power of using options so much here at TradeSmith, we’ve dedicated nearly half of our product line to showing traders how to use them; our swing trading toolset and publication Trade Cycles, our income strategy Constant Cash Flow, and our all-in-one software bundle Options360 are all focused on this great wealth-building tool.
Today, and in future essays, I’m going to show you how to go from zero to options trading hero. We’ll cover some basics today, then get into some more advanced techniques later on.
My hope is that, whenever you go to use options in the future, you’ll use the guide these essays will come to form.
The First Hold on the Wall
Imagine you’re a rock climber. You’re facing that big, intimidating wall with the bell at the top, just waiting to be rung.
That bell is your first profitable options trade. But you can’t grab that first handhold until you get the fundamental technique down.
That’s why today, I want to focus on precisely what options are, and why they can be so useful once you understand them.
Options are essentially insurance policies on stocks. When you buy an option, you acquire certain rights that you can execute, or will automatically execute under certain conditions.
Buying call options is probably the most popular way to trade them. Call options represent your right to buy a stock at a certain price (called the strike price) and by a certain expiration date. As the stock appreciates, so does the value of the call option contract… and vice versa.
When you hold a call option, you have two choices: exercise the contract and buy the underlying stock at the strike price, or sell the call option to another willing buyer.
No matter what you decide, you have to do it before the contract’s expiration date. If you don’t, the market marker decides for you (what happens here depends on if the option is “in the money,” but we’ll cover that another day).
Let’s look at a real-world example.
Imagine you think Apple (AAPL), currently at $227.18 per share, will go up to $235 per share by the end of next week, Sept. 6.
You could just buy the stock and make just under $8 per share if you’re right. But you want to trade an option so you can make a lot more and risk a lot less.
To take advantage of this trade, you’d want the right to buy AAPL at a lower price than your target – let’s say $230.
So you’d buy the AAPL Sept. 6, 2024 $230 call option, currently trading for $2.31. Since options trade in lots of 100 shares, every option contract you buy will cost $231.
Now, let’s skip ahead to Sept. 6. Turns out, you were right! AAPL is trading at $235 per share. And the option you bought, because of that price move, is trading at $5.00 per contract or $500 total. You made $269, more than doubling your money, while only risking $231.
At that point you can either sell the call option for profit or exercise it to buy 100 shares of AAPL for $230. But most will just sell the option in a situation like this.
Here’s where the power of options becomes truly apparent…
If you wanted to make that much money with the same trade setup without using options, you would’ve had to risk a lot more up front.
To make $231 on AAPL shares with an $8-per-share price move, you’d have to buy 29 shares of AAPL for a total outlay of over $6,500.
This is why options are so useful. You’re able to leverage – there’s that word again – small stock moves into big price gains. But unlike the hedge funds who risk millions of dollars and have much higher risk, your risk is clearly defined by what you put in.
Now, keep in mind, if you don’t see the move you want out of the stock, the option will fall in value. If it doesn’t reach the strike price by the expiration date, the value will fall to zero, and you’ll see a 100% loss.
That sounds bad – nobody wants a total loss on an investment. But you have to think about the risk vs. reward on trades like these.
In our example, using options, you’re risking far less money in the short term at the chance of more than doubling it. With stock, you’re risking 28 times more money for the same result.
That’s why options are so useful for short-term trading.
But they can do a lot more, too. With the right strategy, options can generate income, let you sell stocks at higher prices, buy them at cheaper prices, and make longer-term trade ideas pay off magnitudes more.
And TradeSmith has devoted millions of dollars and countless hours developing tools to help you do this with the highest odds possible.
We’ll get to all that in time. Today, if you’re a first-time options trader, here’s my advice.
Open up a paper trading account. Lots of brokerages offer them, like Charles Schwab, TradeStation, and Interactive Brokers.
These accounts will give you some amount of “play money” to trade with. You’ll trade the same data you would with real money, but with zero risk.
Use that account to place a few call options trades for yourself. Find a stock you think will go up, and buy a call option on it just like we did today. Note what works, and what doesn’t… and keep practicing.
Then, stay tuned for future issue of TradeSmith Daily where I’ll cover more about the world of options trading and what you can do with this incredible tool… including how all our systems help you make the most of them.
All the best,
Keith Kaplan
CEO, TradeSmith