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The 6-Week Options Trading Kickstarter: Leverage, Debits & Credits, and Time & Velocity

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Steve Smith breaks down important options trading principles.

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MINYANVILLE ORIGINAL

Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.

Before delving into specific options-trading strategies, I'd like to discuss some general principles. Understanding these principles will help us harness the power of options. These are 1) leverage, 2) debit versus credit positions, and 3) time & momentum.

Leverage

The principle of leverage is one of the most alluring aspects of options and stems from the notion that buying one options contract allows a trader to "control" 100 shares of the underlying stock. What this means is that a trader can buy an economic interest in a company for a fraction of the cost of the underlying stock.

For example, with Apple (AAPL) trading around $590, the purchase of 100 shares would cost $59,000. Or even at a standard 50% margin rate, that buy would require a $29,500 commitment.

Now compare that to a January 2013 $550 call, which trades for $65 per contract, or $6,500. That's just 11% of the capital outlay required for a stock purchase, or 22% for one done on margin. So for a fraction of the cost, we are "controlling" 100 shares, which is the essence of leverage.

Here is the reason I chose this particular contract: It is some $40 in-the-money and has over five months until expiration, meaning it has a relatively high delta of 0.72 and a low theta of 0.09. Therefore, its price behavior will closely approximate that of the underlying Apple shares. For a review of how delta and theta reflect on option's price please refer to last week's article on the Options Greeks.

We can increase our leverage by choosing an out-of-the-money option with a shorter life span.

For example, there is the $610 call with September 2012 expiration that would only cost $12, or $1,200 per contract.

But leverage can cut both ways. While an investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index, it also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Basically, if a stock's price doesn't increase prior to expiration, the option will expire worthless resulting in a 100% loss.

Also, a modest rally may not be enough to cover the time premium of the in-the-money option. In the example above, the January $550 call has $25 worth of time premium, meaning that the breakeven point is $575 per share. The out-of the-money call is comprised of all time premium or extrinsic value, which means that it will take a 3.3% rally for that September $610 call to have intrinsic value.

On the other hand, someone holding the underlying stock will make money if the stock rallies only modestly.

One of the best ways to manage leverage is to use delta, rather than dollar amount, to determine the number of contracts and at what strike price they should be purchased. That is, if one were willing and able to buy 100 shares of Apple, it would not make sense to spend $59,000 on call options. Rather, choose a strike that would give you a delta equivalent of 100 shares. In our examples above, that would be 1.3 (call it two) of the January $550 calls, or five of the September $610 calls, which would cost $13,000 or $6,000 respectively.

Credit Vs. Debit

As we know, options can be both bought or sold short. And just like a stock, the risk to being long is limited to the cost of the trade, while the profit potential is theoretically unlimited.

Conversely, when one is short, the reward is limited to the sale price, but the loss is theoretically unlimited.

Nevertheless, remember that options are a decaying asset with a defined lifespan. This can be used to our advantage, but can also be a headwind.

For example, take the recent plummet in Chipotle Mexican Grill (CMG) after its disappointing earnings report. One would think that it will have a hard time making much of a price recovery until its next earnings report, at which time it may or may not show that growth has reaccelerated. So buying calls would be presented with the headwind of time decay.

But if one believes that the stock now has limited downside, selling puts might make sense. For example, with the stock trading at $290, buying the September $300 call would cost $10 per contract, meaning that it would require a $20 or 6.8% move to $310 ($10 of premium plus the $10 to get to the $300 strike price) just to break even.

But one can sell a September $280 put for a $10 credit. This put is similarly $10 out-of-the-money, meaning that even if the shares declined $10 or 3.4% over the next six weeks, one would still profit by virtue of time decay, and the puts expiring worthless.

The tradeoff is that the short put has an unlimited loss potential, whereas the long call has limited risk. In general, credit positions have a high probability of success but a less attractive risk/reward profile. One way to mitigate the risks is to use spread strategies. This is a topic I'll touch on in the next article of this series.

Time & Velocity

Successful options trading largely depends on choosing the strategy that will align with your thesis. This is a function of balancing price expectations over a certain time period. Will a stock rocket upward, drop like a stone, or just trend gently? Will it swing wildly back and forth or remain in a narrow range?

The answer to these questions, or your belief of what type of price velocity a stock will have over a given time period, should determine what type of strategy you choose to apply.

A stock's price history will also be a determinant in the option's implied volatility, or IV. Netflix (NFLX), which dropped over 25% on its last earnings report, carries a much higher IV than the relatively stable and predictable Microsoft (MSFT).

And this, too, will be part of the puzzle in piecing together a successful approach to using options.

Option education never ends, and the learning process is more circular than curved, but understanding some of these principles will set you in the right direction.

But now that we've gotten the basics down, we're ready to dive into real trading strategies. So stay tuned for next week's article!

1. What Are Options, and Why Should We Care About Them?
2. Option Pricing Basics
3. Meet the Greeks
4. Leverage, Debits & Credits, and Time & Velocity
5. Covered Calls
6. Hedging, Portfolio Protection, and Avoiding Disaster

Twitter: @steve13smith

For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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