Alright, Tackle Traders!!!  We have seen how it works putting on our first live trade.  We now have a routine that can be repeated over and over again to put ourselves into a position to win.  If we follow our procedures and our rules then we will launch ourselves towards market success. Over the course of this blog to this point, we have thrown all the ingredients for stock success together but the eternal question remains, is that all there is?  Of course, the answer to that is a resounding no!  The world of trading is so vast that we couldn’t possibly cover it all in a few blog posts.  We have just scratched the surface of trading and now we are going to church up our ability to earn higher ROI’s by adding options to the mix.  The first option play that most rookies get into is the Long Call.  This is like buying stock on steroids!!!  If this trade goes your way then the payoffs can be massive.  However, if we have massive potential for gains what must we have as well?  Massive opportunity for losses?   Not necessarily.  Heres the thing, most people believe options are risky but you folks as Tackle Traders know otherwise or you will soon enough because yours truly is going to make sure you do.  See the lay people, or non-traders think options are risky because you can lose 100% of your position in an option and if you don’t know what your doing this can and will happen, however, what if the loss of 100% of your option was less than 20% of your stock loss in real dollar terms, which is riskier?

Let’s do some math to see what is riskier, stocks or options?

We have ZYX stock and it is trading at $50 per share.  Let’s say that we believe that ZYX stock can go up to $60 per share after looking at the chart.  We can do one of two things, we can buy the stock or we can buy an option called a long call.  Let’s examine both scenarios.

Buying the Stock – We buy 100 shares at $50 per share for a total of $5000.

Buying the Call – We buy 1 Call option contract for $5 per shares (1 contract = 100 shares)  Our cost is $500 total.

If ZYX stock falls to $40 per share because we wrong on our technical analysis or maybe the CEO did something terrible, either can happen.  What would the damage look like?

Stock = At this point, our 100 shares of stock would now be worth $4000 or in other words, we would be staring at a $1000 loss at this point.

Option = Our option at this point would be worth considerably less as well because the stocks price went in the wrong direction as we thought it would.  Our option at this point might only be worth a $0.05 depending on certain factors that we shall discuss later.

So let’s tally the damage,  $1000 loss in the stock, which by the way represents the 20% haircut I mentioned earlier or we have taken pretty much a 100% loss on our option position, I know it worth about $5.00 total but for argument’s sake it’s pretty much gone.  That $5 will barely cover commission.  So our total 100% loss = $500 or the amount we paid for the option contract, we cannot lose more than that no matter what happens so at the end of the day we took less risk by buying the option even though our % loss was actually more.

So, now can you see that options are not as risky as everyone believes they are?  Options do have risk and we as traders know that and we must embrace that as well but we can use these levers as tools to hunt down the elusive higher ROI’s.

There are a few things that I didn’t include in the above example, its the nuances that I spoke about last week.  You see an option contract is a contract that has a buying and selling feature to it just like buying stock but it has some other components to it that are equally or possibly more important than just buying and selling.  These two nuances are time and volatility.  The option contract has an expiry date unlike that of stock and this is another reason why people think options are riskier.  It is because the option will be worthless at some point whereas stock can be held onto until the price either rises or the company goes bankrupt.  I hope you do not subscribe to this common theory, the wait and hope method of investing.  This is a common practice of investors who find themselves in a losing position, they say “oh it will come back I’ll just wait”.  That kind of thinking doesn’t take into account a couple of things, first, it doesn’t account for the value of time, meaning the opportunity cost of parking money in a losing position, that money may have been better employed into other areas that could create a return for the investor.  Secondly, there is no guarantee that when the stock market does reverse, and it usually does,  that it will be one of the equities that come back, just ask anyone holding Blockbuster or Nortel stock.  So we need to consider time in our decision to purchase options.  We also need to look at volatility.  Volatility is the likelihood of a certain amount of movement that an equity is subject too on a regular basis.   Some call this dispersion of movement for a particular equity but that doesn’t really do it justice.  What we really need to know about volatility is how it affects our trades and in this case volatility, implied volatility is just one metric that is used to determine option pricing.  This is important to us so that we know what our risk would be if we bought a certain option.

There are other factors involved with options but we will start with these two as they are the most important for this particular option play, the long call.  Now that we have defined what we need to know before making an option play we can work into actually using these metrics and how we protect ourselves from them and also how we enhance our ROI’s because of them.

Next week we will look at the option chain and see if we can’t make some sense out of these two and also start looking for a trade that would fit well with our rules and criteria for this type of trade.  We will go through the rules and criteria in next weeks episode and then see if we can’t find a decent candidate to throw a trade on!