Disclaimer: We here at skillbuilderdad.com are neither financial advisors nor professionals. This article expresses the opinions from the personnel at skillbuilderdad.com, and is for inspirational and educational purposes only. The investment decisions you choose to make are 100% YOUR responsibility. Investing of any kind involves risk, and options trading can involve BIG risk with BIG losses. It is recommend that you consult a financial advisor before making any trades.
Oh the benefit of a lottery ticket: make a small investment for the potential of an EXTREMELY large reward. How do we do this with options in the stock market?
If you followed the advice written in the last paragraph of Options Part 1, then you did exactly that: you purchased a lottery ticket for $1 (excluding commission fees). Remember how I stated call options increase in value when a stock rises in price? This is where things get really interesting and FUN. For example, I will show you how to easily gain 5X on your investment from a fairly reasonable move in a stock.
Let’s say you wanted to be a big spender and instead of buying a call option for $1, you decided to pay $12 for one call option contract, as shown in the bottom left of the image below (circled in green):
The top red line is drawn at the transition point where the table switches colors from blue to white. Remember, this is the place where the table tells us the stock is trading for somewhere between $24.50 and $25.00 per share. Next, imagine if this transition point moved down four rows, which would tell us that the stock started trading for somewhere between $26.50 and $27.00 per share. The transition line moves down, and guess what? the call option values increase with it. Look at the 0.60 option (circled in green), which is two numbers below the initial red line (also known in financial jargon as being two strikes “out of the money”). The 0.12 option will increase to the value of the 0.60, since it is now only two numbers below the red line. Pretty cool, right? In short: within this example, if the stock increased in value by four strikes ($2/share in this case), your $12 lottery ticket would now be worth $60, for a 5X gain in value!!!
Disadvantage #1: Lottery Ticket Rule
I know what you are thinking: what if I buy 100 lottery tickets ($1,200 in cost), and increased my investment 5X to $6,000 in value? Yes, this is certainly possible, but what is one common trait about a lottery ticket? That’s right, they often expire WORTHLESS. Buying a call option is very similar in nature, so before you think about risking $1,200 on a trade like this, you better be willing to let this cash disappear in the wind if the trade does not go your way. You have been warned.
Disadvantage #2: Time decay
I cannot stress enough the value of looking at multiple option chains for your stock of choice. This gives you a feel for how a call option can change in value from one week to the next, or one month to the next. The further out in time your option chain expiration date is, the more value your call option holds. This is known as time value. For an option chain that expires in 1 month, versus one that expires in 1 week, you will see that the options expiring in 1 week are much cheaper…but remember, you only have 1 week until all the options in the chain expire worthless. With this strategy, it is worth it to pay the extra money for a longer period of time, which gives the stock more time to make it’s move in your favor. Keep in mind that as the day gets closer to your option chain expiration date, the value of your option will decrease. Welcome to the disadvantage of TIME DECAY. Other strategies will take advantage of this time decay, as I will detail for you in future posts.
Although there are a couple disadvantages to buying call options, the opportunity to multiply your money is fairly easy to do when you hit the proverbial jackpot. I remember a trade I made in 2019, where I purchased a TSLA call option for around $700. Tesla stock went up and within a few days, my option was worth over $7000. This is by far the most thrilling strategy I use in the options trading realm, but is also my least likely strategy to get consistent wins. Remember to have fun, and to buy call options like lottery tickets: a little at a time.