What does a basic option trade look like?
Instead of inventing a fictional company, let’s take a look at two real-world stocks, with the caveat that I am taking this real-world situation and using it to highlight two fictional trades. I don’t have a position in either of these stocks, they are merely in the headlines at the moment. Also, I am going to round the numbers off to make the examples easier to follow and understand.
Lastly, it’s worth mentioning that I’m doing this in realtime, and that the opinions I’m expressing about the stocks are not necessarily my actual thoughts on the companies. There, let’s get started.
Amazon and Facebook
We all know who these companies are, right? If you’ve followed the stock market for any time at all you will also know that their ticker symbols are AMZN and FB.
On January 23rd at 12:00 AMZN is trading at $314. FB stock is at $78.
I love Amazon. I love going online and getting my crap in the mail the next day. I hate Facebook. I hate going online and seeing a bunch of meaningless update crap every day.
Okay, so there are two opinions. Now, remember this example is only to show you the basics of an option trade. It isn’t about taking an in-depth look at how to evaluate a company and choose a trade. This is going to be a basic how calls-and-puts work example.
FRIDAY, JAN 23
I love Amazon, all right? And I think that the earnings for the last quarter are going to be great. The earnings report is six days away, on the 29th, and to try and capture what I expect to be a big move to the upside I am going to buy a call option.
Looking at the option table I decide to buy a February 20, 2015 expiration $320 call for $12.00.
This option expires a couple of weeks after the earnings report. The $320 call is out-of-the-money, which means that if it expired today it would be worthless, but since it doesn’t expire for a month it still commands a premium of $12.00, which translates to $1,200, since 1 call option gives you the the right to buy 100 shares of stock (thus, $12.00 x 100 = $1,200).
So—important point here—that $1,200 you paid for that call option is your total risk on this position. It is impossible to lose more than what you pay for an option. However, it is important to remember that it is very easy to lose that full amount if you aren’t careful. For now, it’s enough just to know that you paid $1,200 for a $320 call that expires in a month.
Uggh, Facebook. It feels like only the friends that I roll my eyes about are still on Facebook. They have earnings next week too, on the 28th, and I am sure Mark Zuckerberg is going to finally have to admit that they are losing users hand over fist. This stock is going down hard, and I’m going to profit off of that fall. I’m going to buy a put option.
With this one I decide on a $80 put with a February 20, 2015 expiration. I pay $4.00 for the privilege.
The $80 put is already in-the-money. If it expired today it would be worth $2.00 ($80 strike price – $78 stock price). At $4.00 for the option, the total outlay from my account is $400 ($4.00 x 100 shares).
MONDAY, JAN 26
Quiet day, stocks down a bit on no news.
TUESDAY, JAN 27
Stock market getting battered overall. Everything getting dragged lower.
WEDNESDAY, JAN 28
Stock market down over 1% again today.
Amazon is now $10, or 3% lower than it was when I bought the calls last week. The February 20, 2015 expiration $320 call that I bought for $12.00 is now trading at $8.30. That’s a 31% decline.
Meanwhile, the Facebook February 20, 2015 $80 put I paid $4.00 for is now trading at $5.60, a nice 40% gain.
THURSDAY, JAN 29
Facebook earnings came out after the bell (close of the market) yesterday. Revenues were way up, but expenses were even higher, knocking the stock down.
Nobody, it appears, was sure how to interpret the results of the report. The stock opened up higher, climbing to nearly $78 again before tumbling in minutes to near $74.
Even near the low though, the February 20,2015 $80 put remained virtually unchanged at $5.50. The sole reason for this was the steep drop in implied volatility. That’s a discussion that merits its own lesson, but I’ll summarize here by saying that once the uncertainty was taken away (i.e. the report was released and nothing incredibly shocking came out of it) the value of all options decreased significantly. Thus, even though the stock was down over $1.50 the in-the-money put option remained unchanged.
I bailed out on this trade when the opportunity to get out at $5.50 came about.
So, let’s see, we purchased this put six days ago for $4.00 (or $400 since we multiply the option price by 100 shares), and we sold it for $5.50 ($550) for a total profit of $150, or 37.5%. Meanwhile the stock itself only dropped in value by about 4%.
Amazon stock continued to tumble in morning trade. Now down $14 since we purchased the February 20, 2015 expiration $320 call for $12.00. That call option is currently trading at $8.00. They report earnings after the closing bell today, but at this point the report is going to have to be nothing short of miraculous to see this call option come back.
A few hours later:
Well, the stock rebounded on the day and settled at 312, with the $320 call trading at $10.70. After the close of the market Amazon reported their holiday quarter earnings and blew away analyst expectations. Shares in after hours trading immediately jumped to $350. If shares remain there overnight I would expect the $320 call to open trading somewhere around $32.00, about a 150% profit.
FRIDAY, JANUARY 30
I sold the call just after the open for $31.00, a 158% profit.
So yeah, that’s two pretty awesome hypothetical trades. Between the two I paid $1,600 and sold for $3,650. Again though, these were only to give an example of how options work. They were definitely not well-reasoned thought-out trades for a beginning trader. I simply knew earnings were a week away, grabbed two stocks I’m familiar with, and threw on two hypothetical trades.
Let’s take a look at a couple more, here.