Stock options are as mysterious as they are lucrative. Most people immediately assume options are tied to huge risk, but that’s not always the case. Stock options are pliable (like real estate), you can morph them into any kind of exposure you want, from conservative monthly income to aggressive weekly bets. You must be cautious when trading options though, ignorance will not be shown sympathy. I was shown no sympathy, compassion or favoritism in 2012, when I lost $20,000 trading stock options, a year when the general market was up almost 12%. Learn how to avoid these mistakes and demystify stock options.

What the hell are stock options anyways?

According to Investopedia, a stock option is, “a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date”. A stock option acts just like a real estate contract; where you can exercise your option to buy the property on the contract date or assign the contract to another buyer. (See why I don’t like wholesaling).

One stock-option contract controls 100 shares of the underlying asset. Therefore, you buy one Jan 17 AAPL call option contract at the $111 strike for 3.61 which costs you $361 (100 x 3.61). You now have the right to buy 100 shares of Apple at $111 on January 17th, regardless of whether the stock price is $100 or $120.

The stock options are composed of two pieces; intrinsic and time value. These two components determine the price of the option at any given time. Intrinsic value is the real value of the option whereas the time value of the option is the value associated with the time left till the expiration date, the more time left till expiration the more time value.

Using the same example above; Apple’s stock price increased to $115/share on January 9th. Therefore, your stock option that you purchased on December 31st for 3.61 is now worth 7.00 (3.61+4.00-0.61). The 4.00 is the intrinsic value of the option which is the difference between the current stock price and your strike ($115-$111). The 0.61 is the time value you lost between December 31st and January 9th. At expiration the time value will be zero and the only value left in the option is the intrinsic value.

There are two main option types; calls and puts. If you buy a call the value will rise as the stock price rises, conversely if you buy a put the value will rise as the stock price falls. An easy way to remember the direction calls and puts increase in value is a phone. To make a call you pick up the phone and when you’re done you put down the phone.

You can buy and sell calls and puts simultaneously to take advantage of more specific types of stock price movements. Some of which include; straddles, strangles, vertical spreads, and butterflies. These strategies are a sucker’s game, like the slot machines in a casino.

My experience with stock options

I have briefly expressed my dislike for stock options in the past. I have no issues with the concept of leveraging money (especially for real estate) but, unlike investing in the market, stock options are a zero-sum game. With each trade of stock options there here is a winner (usually big institutions) and a loser (retail investors like you and me), whereas investing in stocks or real estate allows everyone to make money when the stock or property increases in value. Some face a moral struggle when there has to be a loser for there to be a winner, and I agree. Tony Robbins has a philosophy that resonated with me; the quickest way to wealth is to do more for others than anyone else, which is why now I put all my efforts into real estate.

I bought by first stock under the direction of my father when I was 12 years old. I doubled my money and wanted subsequent trades to be just as lucrative. After investing in stocks for six or seven years I turned to stock options to boost my returns. I read a few books and did my research about trading stock options. You could buy a stock option, which can be 5-10% of the stock investment, lowering your initial investment, and increasing your rate of returns. (See how I use BRRRR to boost my real estate returns).

I began trading just a few hundred dollars here and there, pretty much breaking even. So, I started to increase my bets until I was leveraging several thousand dollars. I doubled my money in Apple twice within six months, giving me a false sense of confidence and control.

I began selling naked puts, anyone with experience in stock options knows this can be extremely risky if done carelessly. I sold weekly options on Nike for about three months, each week netting about $500. Now these were the returns I was looking for!

With a thought that the train ride would never end I sold a naked put option on Netflix just before earnings. I made another $500 and all Netflix had to do was stay above the current stock price. Then the inevitable happened, Netflix’s price dropped substantially. There was no way to get out of this trade unscathed. When the expiration date arrived I owed someone $3,500. My stomach churned. I couldn’t sleep for days thinking how I was going to make that money back.

After several months trying to makeup the losses I found myself getting into a deeper hole, totaling $20,000. After the number hit $20,000 I finally realized the best way to get out of a hole is to stop digging. I was tired of the sleepless nights, hanging onto every word of Jim Cramer and spending hours glued to my laptop and cell phone.

It took $20,000 for me to realize it’s a sucker’s game to use the options market to get rich overnight. That’s not to say you can’t use stock options intelligently with a get-rich-carefully mentality but, as I said before, it’s a zero-sum game that I don’t necessarily like to play.

How to utilize options

There are only three times when I condone using stock options:

·         Protection – To limit your downside you can always buy put options. A put option will increase in value as the underlying stock goes down. A good time to utilize this strategy is when you think the market is headed for a turbulent time, but you don’t want to sell any of your position. Think of buying put options as an insurance policy.

·         Income – To generate more income in your portfolio you can sell covered calls. This will allow you to profit each time you sell a call which can be utilized on a monthly, quarterly or yearly basis. Think of selling covered calls as a dividend.

·         Buying – To generate a small amount of income when buying a particular stock you can sell covered put options. When you sell a put option you are agreeing to buy 100 shares of that underlying security at the strike price, and for that agreement you receive some instant cash when selling the put. I would only use this strategy if; (1) you have the money to buy 100 shares at the put option strike price and (2) you would be happy to own the shares at the put option strike price. If you follow these two criteria then the worst that can happen is you buy the stock at a price you wanted and get paid to do so.

I didn’t go into too much detail about calls and puts or elaborate on stock option strategies for two reasons; (1) the majority of the readers are real estate investors and (2) most of the complicated strategies are a suckers game. To most effectively use stock options the investor must have the capital to buy at least 100 shares while maintaining his/her asset allocation, which is especially difficult when trying to trade stocks like Google and Apple. Use the above advice to help avoid the traps of the stock market and remember, nothing beats well-managed rental real estate.

Main takeaways

·         The options market is a time-consuming zero-sum game; there is a winner and a loser with every trade.

·         To use options effectively you need to have the capital to buy/sell a minimum of 100 shares while maintaining the proper asset allocation.

·         There are three scenarios when using stock options is prudent;

o    Protection

o    Income

o    Buying

·         Although stock options can be advantageous, nothing beats investing in well managed rental real estate.

·         Be cautious. Do your homework and remember with any investment - ignorance is shown no sympathy.

- Cam