Introduction to Options Trading – Part 1 (PUTS)

I had a few people ask about an introduction to options. In this introduction to options, I will go over some of the basics and talk about the options strategy I use the most, selling puts. In a rising market, It can feel like you are “printing money.” I will also talk about how to buy a put and why you would want to.

I am certainly no expert on options trading but I have done really well so far. I’ve earned $3486 so far this year and have kept no more than $13,000 in my options trading account. You can see all of my options trades on my options tab. I don’t know if it has been mostly luck but hopefully, I will be able to give some advice or tips from what I have learned over the last 1 1/2 years.

Before I begin, I previously posted my 2012 year-end options results here. This covers some of the basics and also a lot of the tax implications of options.

So what are options? From Wikipedia:

An option is “a promise which meets the requirements for a formation of a contract and limits the promisor’s power to envoke an offer.”

Options typically exist in one of two forms:

Put Options – A put option gives the holder the right to sell a specific stock at a set price, the “strike price” , on or before a specified date.

Call Options – A call option gives the holder the right to buy a specific stock at a set price on or before a specific date.

Additional options terminology you should know before we continue:

Strike Price – The strike price is a fixed price at which the owner of this option may buy or sell said security.

Premium – This is the income received by buying or selling an options contract(s).

Expiration Date – This is the last day that the options contract is valid.

Example of selling a put:

Let’s use Coca-Cola (KO) as an example. As of this writing, KO shares are currently trading at $39.46/share. I really like KO stock and want to buy more but I believe that Coca-Cola may be slightly overvalued. However, I determine that I’m willing to purchase KO shares on for $37/share or less. Well, I could sell an option contract in order to “try” to buy more KO stock at this cheaper price. The worst case is that KO’s price doesn’t drop and I get to keep the premium.

I decided to look about 5-6 months out in time. Below you can see the Jan 18 ’14 KO Puts around $40 strike. Since I’m selling a put, the bid price is the price I’m going to get paid to sell this put option. Keep in mind that the longer the amount of time I’m willing to wait, the higher the premium is.

So what Strike Price will give me a chance to purchase KO for under $37/share?? For the sake of this example we won’t be counting commission costs. So the way you figure your cost basis is to take the Strike Price and subtract the Bid price. So for the $40 Strike, I would subtract $2.17 and come up with $37.83. This is higher than I want to pay so let’s take a look at the $37.50 Strike. If I sell 1 $37.50 KO Jan 18 ’14 Put right now then I would receive $1.05 x 100 = $105. Keep in mind that 1 put is equal to a 100 share lot so you multiply the bid/ask by 100 to figure out your premiums. So if these 100 shares of KO got assigned then my cost basis would be $37.50-$1.05 = $36.45/share. If KO is trading above $37.50/share around Jan 18 ’14 then I would get to keep the $105 for waiting.

To me, selling puts against sold blue-chip companies is a win-win. I’m not worried KO is going out of business. I currently own shares and would like to build a bigger position. The key is trying to buy shares without over-paying. In this example, by waiting 5 months, you are given a chance to own additional shares of KO at a cost of $36.45/share or a 7.6% discount to where KO is currently trading.

Example of buying a put:

Let’s assume I bought the put instead of sold it in my previous example. My break-even (the point where the sloped part of the graph crosses the x-axis) in the above example would be $37.50 (the strike) – $1.06 (the premium paid per share) = $36.44. Any price above $37.50, I have limited my loss to the premium paid. Any price below $36.44/share, I will be making a profit.

Buying puts is a concept that I understand but have not done yet. You are hoping or expecting the stock price to drop between the purchase date and the expiration date. Your loss is only limited to the amount of premium you paid. However, your profit potential can be very high depending on how far the stock drops in price. If you had bought puts in bank stocks before the financial crisis then you could have gotten rich. You are buying the right to sell a particular stock at a pre-determined price. You can do this whether you own the stock or not. Using the example above, let’s assume I bought the $37.50 Jan 18 ’14 Put. It would cost me $1.06 (ask price) x 100 shares = $106. Basically, if KO was trading below $37.50/share then I might want to exercise my right to sell 100 shares for $37.50/share. This trade protects my investment from dropping below $37.50 before the expiration date. If I didn’t own 100 shares of KO then I am basically just betting that KO stock will drop in price enough that I can sell the put back before expiration for more than the premium. As KO stock drops, the bid/ask price of this particular put will rise.

In order to sell options, you will have to apply for an options trading account with your broker. For E*Trade, in order to sell naked puts, I had to get approved for Level-3 options trading using a marginal account. This requires a little bit of prior options experience to get qualified for naked puts. However, most anyone should be approved for basic options trading using a cash account. To better understand this, you can refer to online blogs and resources similar to “margin trading vs option trading explained“.

You will want to have $37.50 x 100 = $3750 in cash to secure the KO trade for a cash account. Once you get approved for marginal trading and naked put selling then you are able to leverage your money to make many more trades. For instance, this particular trade would only require me to have $750 in cash initially. As the price of KO goes up, the bid/ask price will go down. So if KO goes on a run then my margin maintenance requirement will also go down. However, is KO shares drop then I will be required to hold a little more cash to secure this put. I will talk about maximizing your leverage in a future article.

Note: I actually made a real-life put trade with KO recently and have posted that here.

I hope this is helpful and I plan to write another article involving call options, using margin to leverage your trades and some advanced options strategies.