Mar 142021
 

In light of the recent Gamestop short squeeze the subreddit Wall Street Bets (WSB) has exploded in popularity. WSB generally focuses on buying options contracts in anticipation of a big move in a particular stock. Essentially a member will guess (educated or otherwise) that a stock will sharply increase or decrease. They’ll purchase an options contract that will reward them for predicting correctly, and due to the leverage of options contracts they can earn much higher returns compared to holding the underlying stock. It’s easy to make a 100% return or more overnight. Conversely it’s easy to lose 100% overnight.

I’ve been dabbling in trading options for nearly a year now and figured I’d report on my results and explain how options work. I’ve broken it down into 3 levels of complexity and detail

Space Station Level Overview

There are two kinds of options. Puts and Calls. Buying a put is a bet that the stock will decrease, and buying a call a bet it’ll increase. They’re called options because they give you the option, but not the obligation, to buy or sell the stock at a specific price (called strike price) on or before a specific date (expiration date). To place this bet you will pay the option premium, which is collected by the seller of the option.

The option will increase or decrease in value as the underlying stock price changes. To exit the option, you can resell the option on the open market for whatever the premium currently is, or you can wait till the option expires.

At expiration the option will allow you to buy(call the shares) or sell (put up the shares) of the stock at the strike price.

Jet Liner Level Overview

I shouldn’t call them bets, what they actually are is a contract. Moving forward I’m only going to talk about PUT contracts, because I think they’re more interesting since they go up as the stock price decreases.

One options contract is to buy or sell 100 shares of the underlying stock. All contracts have a strike price and expiration date. Normally offered in increments of $1, $5, or more/less depending on the stock. So if I purchase a PUT option I’m entering a contract to have the option to sell 100 shares of the stock at the strike price on or before the expiration date.

Let’s say I think Gamestop (GME) is going down. As of this writing (Feb 21st) it’s trading at about $40. I think it’s going to $35 within the next month and I’m willing to put money on this guess.

I decide to buy a put option at a strike price of $35 that expires on March 19th. The premium for this contract is $3.98. Premium is always shown -per share- so the contract will cost $3.98 x 100 shares = $398.

So if I’m right, and GME drops to, say, $30, on March 19th, I can exercise this option for a profit. I can buy 100 shares of GME for $30 on the open market (100 x $30 = $3000) then turn around and sell those 100 shares for $35/each (the strike price) to the seller of the contract(100 x $35 = $3500). I have a gain of $500, although I paid $398 for the contract so in reality my gain is $102.

What if GME is above $35 on March 19th (my expiration date)? Well then my option expires worthless, because no one would buy GME at, say, $36 then sell it for $35.

So in short, a put option will increase in value as the underlying stock decreases.

Some of you may think $102 on $398 is pretty good. Nothing wrong with a 26% profit. But the trade could have easily resulted in a 100% loss if GME traded above $35. So it’s difficult to justify the small gain for the risk. If the options premium was lower (say $100) our relative profit would have been much higher ($500 – $100 = $400, or 400% profit). So why was the options premium this high?

The main answer is implied volatility (IV). IV is one of the main drivers of options prices, the other one being time till expiration. If IV is high, it means the stock is prone to large fluctuation in share price, and thus it’s more likely for the stock to drop below the strike price.

GME is very volatile so IV is high. On a lower volatility stock trading at around the same levels as GME the options contract may be as low as $50, instead of the $398 that we paid.

Cessna Level Overview

You may have heard the “we’re in the money!” song. While this wasn’t about trading options, the term In The Money (ITM), means that the stock price is below the strike price for a put option, and thus will likely be exercised. If the stock is above the strike it is Out of The Money (OTM).

Consider our $35 put option that we paid $398 for. We don’t profit when the stock drops below the strike, we profit when it drops below the strike minus the premium we paid. This is why contract prices are reported *per-share*. The option price was listed at $3.98. Thus the break even is:

$35 – $3.98 = $31.02

Therefore we only make a profit if GME drops below $31.02.

The second main driver of options premium is time. Specifically the amount of time remaining till expiration. The more time that remains, the more opportunity there is for the stock to move in the desired direction. If we take the same strike price ($35) but choose the March 5th expiration date instead of March 19th, the premium is $2.09 instead of $3.98.

Thinking about this another way, if we purchased the $3.98 option and the stock price didn’t change, in 2 weeks the option would be worth around $2.09. This is known as time decay, or theta decay.

Review and Strategy

In review – a PUT contract is the option to sell 100 shares at the strike price by the expiration date. The break even point is the strike minus premium paid. Implied Volatility and days till expiration (DTE) make options prices more expensive. A decrease in volatility and fewer DTE will reduce options prices.

Knowing this, what’s a good strategy to make money from buying a put option? Get a crystal ball. Or. Think about market trends or upcoming events that many cause the stock price to drop (think earnings reports, or global pandemics). And buy the option before the market gets word, so you can benefit from both the stock dropping and the IV increasing.

How does buying PUTs normally go? Over long time horizons the market will always increases, thus most stocks will increase over time. You would have made an absolute killing buying PUTs during the coronavirus crash, but gotten destroyed nearly anytime after the drop in march since the market recovered so much. I bought puts on 17 stocks in 2020 and only made a profit on 4 of them. I made a lot on those 4, but it wasn’t enough to offset the losses from the other 13.

The Other Side of the Coin – Selling Options

Remember that options are contracts between two parties. There’s no company selling them all. Anyone can be a buyer of options, or a seller (AKA writer) which creates a brand new contract that didn’t exist before. It’s different than stock, which is only issued by the company.

I have been selling options for a couple months now. And of the 22 put options that I’ve sold, I’ve made a profit on 21 of them. And the loss from the loser was very small. Success has been much easier as an options seller than buyer. Although if the market hadn’t rebounded in the past month I might be telling a different story.

Details about Selling Options

When you sell a PUT option everything in the above example is reversed. You still have a strike price an expiration, but instead of wanting the stock to go below that price, you want it to stay above the price. And instead of the premium price decay over time hurting you, it actually helps you.

Let’s say I sold that GME $35 put instead of buying it. Rather than paying $398 I collect a credit of $398. For that payment I take on the obligation to buy 100 shares of GME for $35/share on the expiration date of March 19th. It’s an obligation for me, the seller, but an option for the buyer. So if GME drops to $30 by March 19th I am forced to purchase 100 shares for $35 ($3500) and they’re now worth ($3000). But I keep the $398 premium so my total loss is $102 and I am the proud owner of 100 shares of GME.

I can do whatever I want with those 100 shares. I can sell and realize the $102 loss. Or I can wait and see if GME recovers, or I can sell a call option to create a covered call (not going into that now). I want to emphasize that the $102 loss is unrealized. Meaning it’s not a loss until I sell my new shares. This is in contrast to buying the put where the worst scenario is that it expires worthless.

What if GME stays above $35? The option expires worthless and will not be exercised. However, as the seller I get to keep the $398 premium and thus that becomes my profit. This is the best case scenario for me, the seller.

The inherent risk with selling options comes from being forced to buy the shares for $3500. But what if you don’t have $3500? Luckily your brokerage will know this, and they shouldn’t even let you sell the option in the first place unless you have at least $3500 cash in your account for collateral. This makes your option sale “cash secured”, and if the option expires ITM you have enough cash to pay for the shares that you are obligated to buy.

Thus when calculating returns you can calculate your profit ($398) as a percentage of the secured cash to buy the shares ($3500). In the case of GME my profit would be 11.3% if the option expires worthless. But keep in mind this is realized profit in ~28 days, thus making the annual return 145%. Pretty sweet!

March 5th Update

I wrote the first draft of this article on February 21st and now I’m updating on March 5th. GME has unexpectedly taken off again and is now trading at about $138. So how’s my $35 put doing? The contract is now worth $62, thus I am currently up ($398 – $62) = $362. Conversely the buyer is down $362.

I could “Buy to Close” the contract by purchasing the option for $62 to cover my position and realize $362 of profit. This might be a good idea to free up the reserved $3500 cash so I can deploy it elsewhere. Also if I had any reason to believe that GME might completely crash in the next 2 weeks I could lock in that profit.

If I have the cash to spare and don’t mind waiting I can let the contract expire in 2 weeks to collect the remaining $62.

March 13th Update

The March 19th $35 GME put option is now worth $14. So my profit is now ($398 – $14) = $384. Which means I’ve extracted 96% of my max profit. GME is comfortably at $264 (who could have predicted this…) and it’s highly unlikely that it will lose 87% of its value in a week and drop below my strike price.

Here’s the problem though, what if I had used my $3500 to buy shares of GME instead of selling this option? I could have bought 87 shares when it was at $40, which would now be worth $22,968 for a profit of $19,468. Clearly that would have been the better play, but who could have known it would increase so much? This is not normal activity for any stock.

What if GME had stayed flat or dropped below $35? (which is much more likely for any other stock)

I explained what happens at different prices in the above examples. But we can actually define a range of profitability. If GME is anywhere from $31 to $44 we make a greater profit from selling the option than buying the underlying shares. In other words, buying shares only makes sense if GME rises more than 10%.

In the case that GME drops to $30 our loss would be $102 as explained above, but what if we had purchased $3500 of the shares at $40 and it drops to $30? We would have a loss of $875. So clearly selling this put option gives us greater downside protection. The tradeoff is the maximum profit of $398 vs the $19,468 that would have resulted from buying shares.

One last time, why is selling a put option a good idea?

Selling a put option is essentially being paid to submit a limit order. If you are willing to buy a stock at a certain price that’s below it’s current trading price, you can get paid to wait until it drops to that price.

Alternatively if you think a stock will not drop below a certain price, you can sell the contract in order to harvest the premium.

If you only sell put options on stocks you are willing to own, the worst outcome is being assigned shares of that stock, the best outcome is a regular profit that, although small, will line your pockets with another 20-40% annual return.

It’s definitely not for everyone, and for my loyal Questrade users out there, you’ll have to be very careful with commission fees. Questrade charges a $10 commission to buy or sell a contract. For options trading I use Interactive Brokers, which only charges $1 per contract. However they have other fees that you’ll need to consider. If you are interested in Interactive Brokers Click Here for my referral that will get you up to $1000 in Interactive Brokers stock (depending on how much you deposit in the first year).

Options are way more complex than I am able to explain in this already very long post, so if you’d like to learn more I suggest searching Options Trading for beginners or Cash Secured Puts on YouTube. The channel “In The Money” does a good job of explaining these concepts.

One last note on the buyer of that GME option

Had you purchased the $35 put option you’d be in dire straights. The put is now worth $14 and you’re down 96% on your investment. Ouch. Furthermore it’s likely dropping to zero. So you either have the pain of selling at a 96% loss or waiting for it to expire and losing 100%.

That’s how most of my put options played out. If the underlying didn’t move the option would slowly decay, losing ~5% per day getting more and more red. Occasionally I would get lucky, and the underlying would drop 20% or more resulting in a 3x gain for me. But those were rare events, and one investment tripling would never make up for the other four where I would lose 50-75%.

On paper buying options seems way more attractive. Near unlimited upside and limited downside (the most you can lose is the total value of the contract, but the gains could be 100x your investment if the underlying drops enough). Whereas selling options has limited profit and near unlimited downside (max profit is the contract value, max loss is the strike price x100 if the stock goes to zero). But the attraction of buying options is a sirens call. The statistics are not on your side. Unless you get exceedingly lucky you’re option is likely to decay to a loss. Whereas selling options will likely be profitable unless you get exceedingly unlucky or don’t do your proper research. Options, especially out of the money ones, are kind of like lottery tickets. And who do you think earns more money over time? The sellers or buyers of lottery tickets?

In summary, I have tried both sides, and I have had way more luck selling options compared to buying. I’ll probably continue selling options till I get burned, but for now I’m enjoying the success. Not recommending this to anyone. Just keep up with index funds and you’ll do fine.

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 Posted by at 10:49 am

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