Making Money with Option Strategies

Powerful Hedging Ideas for the Serious Investor to Reduce Portfolio Risks

Michael C. Thomsett, Michael Thomsett

• Publisher: Career Press
• Year: 2025
• Print ISBN: 9781632650467
• eBook ISBN: 9781632659521
• Topic: Personal Development
• Subtopic: Investments & Securities

Making Money With Option Strategies is a practical, down-to-earth guide that introduces and fully explains an action plan to reduce risk in any stock portfolio.There are many options books available already, and they fall into two major categories: basic primers limited to explaining the terminology and market of options; and more advanced books discussing theory and pricing models of options.None of these books addresses the largest audience of all—those who know the basics but are not interested in theories and pricing models. They want clear, practical ways to apply these principles to make money and reduce their risks. Making Money With Option Strategies is designed for this market.Michael has traded options since the mid-1970s and is the best-selling options author in the United States. His best-selling Getting Started in Options, a beginner's book now in its ninth edition, has sold more than 300,000 copies since 1986.Many people view options as exotic, complex, and high-risk beasts. They are not. If your portfolio risk keeps you up at night, adding carefully designed option strategies to hedge risks will help you get a good night's sleep.

1 The Basics of Options

The options market is characterized by specialized jargon and terminology. This chapter explains all of the terms used and places them in context for you, as an investor. Beyond definitions, you also need to grasp the essential trading rules and to be able to read options listings found online or in the financial press.

This chapter presents a broad overview of the options market as a starting point for folding an options strategy into an equity portfolio; identifying specific risks; and understanding how to mitigate or remove an equity-based market risk.

Attributes of the Option Contract

Options are intangible contracts, granting their buyers specific rights (and imposing obligations on sellers). The amazing attribute of options is that they can be used in many ways, covering the spectrum from highly speculative to highly conservative. Most investors cannot be classified as strictly speculative or conservative, but tend to operate within a range of risk levels. These levels change based on the circumstances, including market conditions, stock prices, and the amount of cash in a trading account.

With these variations in mind, options are perfect vehicles due to their flexibility. The degree of risk you can undertake based on how you use options is not fixed any more than your risk tolerance. The leverage of options is very attractive as well. However, depending on how that leverage is applied, it can increase or decrease your risk.

Key Point

Options are intangible contracts granting specific rights to their buyers and obligations to their sellers.

For example, options typically cost 3% to 5% of 100 shares of stock. So buying a single option is a highly leveraged way to benefit from favorable stock price movement—or to suffer the risk of unfavorable movement. The percentage of option cost varies due to the specific terms of that option.

The flexibility of options is one of the primary attractions among investors. In addition to the pure speculator, many conservative investors with a buy-and-hold portfolio will trade options with a small portion of capital, as a form of “side bet” on the market. This not only brings up the chance for added profits, but also allows investors to take advantage of price movement in their stocks. Rather than sell to take profits, options can be used to capture those profits without giving up stock. And when a stock price is likely to decline, options can also be used to limit risks. In other words, options are flexible enough to allow you to manage portfolio risks while continuing to hold stocks in your portfolio.

The Leverage Benefit (and Risk)

Because option values are determined by price movement in the stock itself, the skillful use of options as a leverage tool presents many opportunities. For many, the option is an alternative to actually owning stock, so as a purely speculative tool, the leverage appeals to this group of traders. However, leverage also provides hedging value by setting up risk limitation as well as alternative forms of profit creation based on portfolio positions.

Key Point

Leverage is generally not conservative because it involves borrowing money to invest. Options are the exception, a form of leverage that does not involve borrowing.

Leverage is normally associated with borrowing and, in that regard, most forms of leverage are also high-risk investing strategies. Borrowing money to invest does not seem to most people like a prudent decision. However, even the most conservative investors trade on margin, meaning they can buy 100 shares of stock with 50% cash and 50% leverage. So even when you consider yourself very conservative, you might be using risky leverage in your own margin account.

This means that every investor trading in a margin account is exposed to the risk of leverage through borrowing. This approach might seem wise. You can buy 100 shares of a $50 stock for only $25 per share; as the stock price rises, the return on your $2,500 cash investment is twice as much as it would be when paying all cash. However, if the stock price declines, the loss also is accelerated. So if the $50 stock falls to $42, you lose $800, or 32% of the $2,500 you put at risk. However, you still owe your broker $2,500. Your leveraged debt is $2,500, but the cash portion of your investment has dropped to $1,700.

This demonstrates that leverage based on borrowing money means that both profits and losses are accelerated. So leverage (meaning borrowing money) can represent considerable risks. These risks are removed when you trade options as hedges against your portfolio. You can pay cash to buy options at a small percentage of the cost of 100 shares, and the most you can lose is the amount you pay, never any more.

Terms of Options

To completely understand how options provide hedging benefits, you need to master the jargon of this industry. Every option is uniquely defined by its four standardized terms. These terms define the option and always work in the same way, meaning all of the terms apply to all listed options (thus, they are standardized). So when you buy or sell an option, you know exactly what your contractual terms are for that asset.

The four terms are:

1. Type of option. There are two, and only two, “types” of options: calls and puts. A call grants its owner the right, but not the obligation, to buy 100 shares of stock, at a fixed strike price and by or before its expiration. A put grants its owner the right, but not the obligation, to sell 100 shares of stock, at a fixed strike price and by or before its expiration.

2. Strike price. This is the fixed price at which a call or a put can be traded. This price remains fixed for the entire life of the option regardless of the stock’s price.

3. Underlying security. Every option is tied to a specific stock or other security (such as a stock index or exchange-traded fund, for example). This cannot be changed during the limited lifetime of the option.

4. Expiration date. This is the month and date when each option ceases to exist. Every option is identified by expiration month. In addition, listed options expire on the third Saturday of that month, and the last trading day is the third Friday.

Expression of an option is quite specific and is based on these four standardized terms. Here are two examples:

JNJ Oct 95 c (Johnson & Johnson, call with a 95 strike price, expiring in October)

MCD Mar 100 p (McDonald’s, put with a 100 strike price, expiring in March)

The stock symbol for each stock (JNJ or MCD, for example) is used in an options listing or description. The expiration month is normally reduced to a three-digit summary without a period. The strike is always expressed at the price per share but without dollar signs.

Key Point

Options are expressed in a specific form of shorthand. Mastering these expressions is essential in options trading.

If the option is not a round dollar per share value, it is expressed as dollars and cents to two digits, also without dollar signs. So if the strike is 99.50, that means the strike is equal to $99.50 per share. In describing options and stocks, the use of dollar signs is always used to explain the price per share of stock, but never options. So a 99.50 option on a stock currently priced at $99.75 is how the situation is expressed.

The Price of Options

The price of each option is called its premium and it is always written as the price per share. So if the premium of a 99 call is $215, it is expressed as 2.15. Expanding the listing of an option to include the premium value, the following examples include premium:

JNJ Oct 95 c @ 1.40 (Johnson & Johnson, call with a 95 strike price, expiring in October, with current premium value of 1.40, or $140)

MCD Mar 100 p @ 7 (McDonald’s, put with a 100 strike price, expiring in March, with current premium value of 7, or $700)

Figure 1.1 illustrates the terms of the option.

Figure 1.1: Terms of the Option

Like most securities, options also are expressed at both bid and ask prices. The ask is the price you pay to buy the option, and the bid is the price you receive for selling the option. For example, the JNJ Oct 95 c @ 1.40 is the bid price for that option, or what a seller receives. And the MCD Mar 100 p @ 7 describes a put worth $700.

Long and Short Positions

Expanding beyond the listing, every option can be either bought or sold. The bid price (what sellers receive) and the ask price (what buyers pay) are included in every options listing. When you buy an option, you are long; when you sell, you are short. The distinction is one of sequence. A long position is the well-known “buy-hold-sell” sequence. The short position is the opposite, or “sell-hold-buy.”

This reversal of the sequence is confusing for many investors accustomed to first buying a security and then later selling. However, you can open a position that is either long or short with options, and the risks are different for each. Just as a buyer has the right to buy or sell 100 shares, the seller is exposed to the possibility of exercise, meaning a call owner will “call” 100 shares and the seller is required to deliver those shares at the strike, even when the market value is much higher. It also means a put owner will “put” 100 shares to the seller, meaning the seller is required to accept 100 shares at the strike, even when the market value is much lower.

The buyer of an option enters an opening trade, called “buy to open,” and a later a closing trade, called “sell to close.” Everyone who has bought and sold stock is familiar with these definitions. However, for those who enter a short position by opening with a sale, the opening trade is called “sell to open” and the closing trade is called “buy to close.” These distinctions are important because the distinctions—buy versus sell and open versus close—define the action you take each time you trade an option. Many traders describe the closing of a short option as “buying back” the option. This is misleading and confusing, because the buy to close occurs based on the initial opening of a short position. There is no “buying back” action because the trader never owned the position to begin with.

To compare buying and selling consider the important differences betw...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Introduction: Solving the Time and Proximity Issues
• 1: The Basics of Options
• 2: The Hedging Concept and Its Application
• 3: Option Valuation and Portfolio Risk
• 4: Speculation With Options vs. Conservative Strategies
• 5: Charting and Trade Timing
• 6: The Basic Covered Call
• 7: The Uncovered Put: Alternative to Covered Calls With Less Risk
• 8: Hedging With Spreads
• 9: The Butterfly and Condor
• 10: Collars and Synthetic Stock
• 11: Straddles Hedged
• 12: Rolling and Recovery Strategies
• 13: Avoiding Early Exercise of Short Options
• 14: Collateral and Tax Rules for Options Trading
• 15: The Final Twist: Proximity
• Glossary
• Bibliography
• Index
• About the Author