Trading Options
One of the most frequent requests I have been getting in the
comments section has been to talk a bit about options. So here we go.
Let's make this a happy story and focus
on a successful call option trade. In particular, a call option for a stock I suggested
way back in an October 6, 2006, post. The stock was Immucor, symbol BLUD.
At
the time, the stock was at about $25. Now let's suppose you had so much
faith in this chart that you didn't just want to buy the stock, you
wanted to buy the call option (in order to leverage your investment and
possibly enjoy great percentage gains).
Well, let's slow down
for just a minute and do the most important thing first: figure out a
stop-loss price. In other words, figure out at what price we would
consider our speculation incorrect. In the case of BLUD, the deepest
point of the most recent dip in this chart was at $21.57, about $4 less
than its current price. So we decide that if the price ever dips below
this level, we will close out our position at once.
Next
we have to pick an option - - we'll want a call option, of course,
since we're bullish on the stock. I typically look for a number of
properties in the option I choose:
- I'd like it to be a little in the money; so in this case, we'd want a $25 call, since the stock is a little over that amount
- I'd
like the expiration to be at least two or three months down the road.
If you get the "front month", the time decay will eat you alive. But if
you buy an option that's a year down the road, the movement in the
stock will have a very dampened effect on the price of the option. So
right now it's January, and I'd be looking at Marches or Aprils (at the
time of the BLUD suggestion, a January option would have been
appropriate).
- I want to see relatively beefy volume and
open interest. It's not easy to find with options (except for huge ones
like the S&P 500).
- I want to see a bid/ask spread
that's not big enough to drive a truck through. If an option is bid
5.30, ask 6.50, I'm not interested. Focusing on rule (3) will help get
you away from overly fat spreads.
So, for instance,
here's a chunk of an options screen showing the S&P options; the
one I've highlighted is interesting since its volume and open interest
stand out above the others, plus, it's in-the-money.
Once
the order is placed, I immediately want to get a contingent order
placed. This means that if the stock goes above (in the case of a put)
or below (in the case of a call) a certain price, a market order will
be immediately placed to close that position at the best available
price.
Those
are pretty much the steps. Once they are in place, one of several
things can happen. The stock can move in the direction you anticipated,
which will benefit the option even more. Or the stock can move against
you, pushing past your stop price, and closing the position at a loss.
Or the stock can just meander along, which isn't something you can
tolerate for long because the option will expire at some point!
Now
let's see the happy ending to this story. BLUD went up about 30% since
the suggestion back in October. But the option went up hundreds of
percent! That's the beauty of leverage. Now, I admit, this is a fairly
idealized example. But the important things to note are: (a) some of
the rules to follow (b) the importance of stops (c) the power of
leverage, if things go your way!
A couple of closing remarks. First, options are a highly-leveraged investment, and you can wipe out your account in no time if you are careless. Tread lightly. Second - and this is a personal bias - I have a strong liking for the Russell 2000 ($RUT) for index options. I find the S&P options to be a complete and utter rip-off. Which is strange, considering their volume and popularity.
Good luck, and again, be very careful out there!
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