A lot of people that get into trading options understand that there’s probably four parts to the trade.
4 Parts of a Trade
- You could buy a put
- You could buy a call
- You could sell a put
- You can sell a call
Each one of these gives you a different way to make money or profit depending on the contract position that you have on the trade.
So you could be a buyer or a seller.
Why would you buy a call rather than selling a put? Why would you sell a put rather than buy a call? What’s the advantage and disadvantage to these things?
I hear people talk about that it’s the same exact thing and it’s not. It’s actually very different. There’s very different concepts when it comes to the liabilities part because you’re dealing with legal contracts. But that’s what we’re going to cover here in a little more detail.
When we look at buying a call this is the profit, the zero line and the price of the stock
So when we look at buying a call the structure and the risk profile picture of buying a call looks something like this
What does that mean? That means that as we look to our line, this is the line at expiration.
Here’s the line today.
This is called the T+0 line in the industry. When we look at the T+0 line here, if you get this at around 170, where it’s the break even. So there it is at zero with time that line gets closer and closer to expiration.
Which means you have a theta decay that’s negative. When the green line gets closer to the black line, you’re losing money when you buy a call.
Now what’s the cool thing about this? What’s great about it? Well, you have unlimited profit potential. Stock moves, you have a very fast delta. In other words, you can make a lot of money if the stock moves in your favor .
What’s the downside?
We lose money:
- If the stock stands still.
- If the stock goes down or up a little.
This is because of the time value problem that we have.
Options lose money with time.
The only time you make money is the stock has to go up a lot. It has to go up a lot enough to cover the difference of the premium you lose. Because if it moves right away you’re good.
If it moves a little bit later, let’s say this was 30 days, and it moves in two days, you’re fine. If it moves 20 days from now, well you might need a way bigger move to make it work and happen.
That’s one of the issues but it’s still an upward move. So let’s check out selling a put.
Some people wonder well why in the world would you sell a put. We got a call and you can make unlimited amount of money. The way I look at it is I don’t believe in stocks going up to the moon.
That’s just my world view and perspective. I just don’t think it’s going to happen. I mean some stocks do but it really doesn’t most of the time.
So here’s kind of what happens when we sell a put.
You still make money from the stock heading higher.
Let’s say here’s our price.
What’s bad about this? What is good or great about this?
What’s great is stock can stand still and you still make money. Why? Because you have a positive delta.
Think of your insurance company.
Who makes more money in the insurance industry, is it you the buyer? Or is it the seller when they sell you car insurance?
Think of it like this, when you buy car insurance, is money coming out of your wallet and going into theirs? Or is money coming out of their wallet and are they sending you checks?
No. It’s not going into your bank account. You’re taking money out of your wallet and you’re handing it to the insurance company.
The same thing here, most of the time the big businesses make money by selling.
Anybody makes money by selling a product. So as we look into this, you typically want to be a net seller.
What’s the downside?
If nobody buys your stuff or products, you got problems.
Here we’re in the insurance business, if we got a crash, stock goes down. We could lose quite a bit of money because you have unlimited risk up until zero.
But the good news is,
- stock stands still, you make money.
- stock goes up, you make money.
- stock goes down a little, you still make money.
The problem is, if it goes down a lot, then you can lose some money.
Here when we look at this you do have the positive theta.
Why would you do this? Because you’ve got a higher probability and chance of success.
Think of it, would you rather have an 80% chance of success and make 200 dollars or a 10% chance of success and make 4000 dollars? Some of you will say the 10%. I’ll take the 10 because I’m gonna make a lot more
The thing with this business is you want consistency. This is where people fail because you’re making money time and time again. Maybe you’re making less but you’re consistent. Whereas a lot of people choose this 10% probability of success. They might make a lot more but every time they buy a call, they’re getting a lower chance of success.
You’re losing out and you’re constantly paying this premium. You’re losing 1200 four times and eventually you might make your 4 000 but you’re constantly losing money to make that.
How does this look in a trading panel and platform?
Let’s go ahead on Disney here.
The current stock price is about 110. We will go in say 53 days.
I’ll buy the single at the 120 and we’ll just say 10 contracts just for conversation’s sake. I’ve got my calls on Disney.
So stock goes up, I’m making money. Problem is, I got a theta of negative 54.
What in the world does that mean? That basically means I lose 55 dollars in every single day.
So watch this white line, if it just stands still, I lose 3500 dollars. Those people will think buying a call is better. You’re losing 3500 dollars if it doesn’t work.
Now, is there situations that you would do this? Yeah, absolutely. But for beginner, be careful.
Let’s look what happens with the T+0.
As I move this date forward, every day you’re losing money.
Your profit and loss continues to decay. White line gets closer to the green line.
Look just to break even.
You’ve got to get that stock to go up like 3 to 4 bucks. If I keep going and it moves later in time,
I got to get it go up like 6 to 7 bucks. If it gets close to expiration, well I’m almost down 3,000 dollars, I got to get that stock to go up like 9 dollars if it just stood still.
So that’s the issue just to break even. It’s got to move in that direction.
You could make a fortune, right? There’s your four grand but it’s it’s really got to move
Let’s take a look at selling a put. Look at the difference here.
I’ve got a positive 65 theta versus the other one which is negative 55 theta.
Now what does that mean?
- Stock stands still, I make money.
- Stock goes up, I make money.
- Stock pulls back even a little bit, I still make money.
The only problem is, I have this downside movement. So here watch this date closely.
Stand still, you’re already up a thousand bucks.
Then you can get out of it early. You don’t have to stay in it the whole time.
Now again this depends on your risk management. But you could say 4500 thousand dollars every 40 to 60 days. This is considered a naked position that if it does go against you, you could have some astronomical losses. This is what some people will argue, if stock goes to zero you could have almost a 100,000 dollars in losses.
This is where you get into the risk management business of this. Really learning and understanding what in the world you’re doing. So if you’re just starting out I wouldn’t recommend doing this from scratch, all on your own.
How do you protect this trade?
Well here’s what I would do, we would buy some protection. Analyze the trade and now look what I did
I flattened and cut off my risk there Now does that kill and reduce my theta? Yeah it does because I have to buy this protection. The one that I buy loses 43 dollars.
The one that I sell makes me 65 dollars a day.
That protection cost me 43 dollars a day. I’m losing 43 dollars a day but the one I’m selling, I’m making 65 dollars a day. Net total — I’m making 22 dollars a day.
That’s still better in my opinion.
I don’t have a negative position.
On a day-to-day basis, I still have a positive position. Your upside is limited that’s the issue. Selling is how you make money even in a stock.
If you invest in a stock, you don’t make money by buying it.
You make money by selling it. When you sell it, that’s when you collect your premium and profit So you buy it first and then you sell it.
In our case we’re selling it and later on we would buy back.
Whereas when you’re buying a call, this is why a lot of people lose money in options.
Most of the things you bought, losses its value. It’s got to really move quite a bit for you to pan out and and make money on these. If you’ve been trading these and you’ve been losing out money then it’s because of this time decay problem that you have.