Jan 23, 2023
Is the first thing that comes to mind when you hear the words "options trading" ... Risk? So many retail investors have lost money “betting” on options. Some experts argue that to gain an edge trading options, you need to know which direction a stock will move, how much it will move, and when it will move. But if you've misplaced your crystal ball, Olive can give you an edge to manage risk and reward better with options.
But first, the basics. There are two kinds of options: call options and put options. Buying a call option gives the buyer the right to buy the underlying asset at a specified price and by a specified date. Buying a put option gives the buyer the right to sell the underlying asset at a specified price and by a specified date. On the flip side, a seller of either a call or a put option would have the obligation to sell or to buy the underlying asset at a specified price if the option owner decides to exercise their right before the expiration date.
Most retail investors only buy options. Intrinsically, buying a single leg call or a single leg put option is indeed betting on the direction, magnitude, and timing of the underlying stock’s move. You pay a premium for the right to buy or sell a stock at a specified price by a specified date. If you are wrong on any of the three dimensions, then you lose 100% of your investment at expiration. As you can see, buying single leg options is a losing game with the chips stacked against the average retail investor.
Level up by combining options. As you see above, there are four basic actions you can take on option legs: buy a call, sell a call, buy a put, or sell a put. When you combine any or all of these actions and vary the quantities you gain greater control to achieve your desired outcome.
Let's compare with an example:
Buying call options. $GOOGL is trading at $100 per share and you have $10,000 to invest. A call option contract expiring in one year with a $100 strike has a premium of $10. This means for $10,000 you will get 10 contracts because each contract entitles you to buy 100 shares and the premium is always quoted per share. If $GOOGL trades above $110 ($100 strike + $10 premium) at expiration, then you will stand to make a lot of profit. For instance, $GOOGL at $120 per share at expiration would give you $10,000 of profit or 100% return even though the stock is only up 20%. However, if $GOOGL trades below $110 at expiration, you will face a loss and if it trades below $100, you would lose all $10,000 or 100% of your investment.
Using a multi-leg strategy. Using the same facts above, you can define an entirely different outcome by executing a multi-leg strategy, here we'll create a call spread with a short put. Let's say the same expiry $80 strike put option has a premium of $6 and the same expiry $120 strike call option has a premium of $4. You sell the $80 put and sell the $120 call, then with the premium collected you buy the $100 call contract. With credit spreads you pay nothing to open the position (and in some cases, you even collect premium). In this example, you would invest $8,000 (the capital required to secure your sold contracts) and potentially make up to $2,000 or 25% if $GOOGL trades at or above $120 at expiry. At the same time, you would not lose a dime of that capital unless $GOOGL falls below $80 per share or 20% below current price.
As you can see in the example above, with a multi-leg strategy even if you get the direction, magnitude, or timing wrong, you have a better chance of making some profit or breaking even. This is how you can build in margin of safety as a loss cushion in exchange for capping upside.
Multi-leg option strategies are complex and can be difficult to manage with pen and paper. Fortunately, with Olive you have super powerful computers to do the math for you. All you have to do is choose which defined outcomes best suit your risk-reward profile and add them to your portfolio with ease. Join today and start investing smarter with options.
