Trading Contracts in Options
In Stock Trading Basics, we discussed a very optimum way to play the short-term momentum and direction of stock price using options. We introduced the basics of Trading Contracts in Options. In this section, we will take our example a little further and demonstrate what happens when our judgment turns out right as well as what happens when our judgment turns out wrong.
Let us start with where we are at this time. We have bought the October 2009 $650 call options on GOOG at a premium of $1,000 per contract. Let us now assume that GOOG quarterly earnings will be released on October 14 and our call options expire on October 16. Remember that all options expiring on the month expire on the third Friday of the month. Technically they expire on the Saturday afternoon after the third Friday but practically one only has till Friday trading time to take any action before the expiration.
So, in this example, we are good as far as the timing is concerned. We were playing on the earnings release and the expiration date on the options gives us a couple of trading days to make a decision as to what we want to do with the options.
Let us consider the worst scenario first. Let us say that our judgment was totally wrong and GOOG declared earnings on October 14 that were way below the market expectations. So, the stock price is going to drop proportionately perhaps by as much as 10% or down to $540 per share. In this situation, our call options will expire worthless because their strike price is at $650 and the actual stock price is nowhere close to that. We will loose the $1,000 we paid as premium. However, if one compares with what we would have lost if we had invested in the stock itself, the loss on the options is negligible. If we had bought the 100 shares in GOOG at a cost of $60,000, we would have lost $6,000 on that transaction as of now. Instead, we were able to restrict the loss to $1,000 by trading the options instead of the stock directly. This is where trading contracts in options helps in managing risk.
Let us consider now as to what we consider as the best scenario and typically the scenario that we aim for. Let us say that our judgment starts to look right as we see that there are more and more traders who become bullish on the GOOG earnings call. This bullishness makes the stock price already go up to around $620 a month before the earnings call (around September 2009). Remember that the movement in the stock price is based on the expectation that GOOG will declare stellar earnings. The movement in the stock price of GOOG, has in turn, made the premium go higher on the call option. It has reached $2,000 per contract now. The reason the premium has gone up is because the stock price has been moving steadily in the direction of our call option thus making the overall probability of the stock price reach our strike price of $650 more and more possible. We are now in the drivers seat because we can decide if we want to cash in on our gain (which is sitting at 100% as the premium on our call option has doubled) or we want to hold it longer for the stock price to go higher. This gain in the premium demonstrates the leverage of trading contracts in options. Our investment of $1,000 in the call option premium has now gone up to $2,000. Thus we can sell the options back in the market and pocket this increased premium to give us a 100% gain in this trade. That is what we normally end up doing in most trades.
Let us now consider the third scenario where we hold on to the call options till the earnings release is declared as the stock has been trading steadily higher through this entire period. There are two possibilities for this scenario. The GOOG earnings live up to the expectation and the stock price zooms to $700 right after the announcement. We can take delivery of the 100 shares at a strike price of $650 per share even though the market price is currently at $700 or we can sell off the call options at a premium of $5,000 per contract. The reason the premium on the contract is currently at $5,000 is because of what is called the “intrinsic” value of the option. The strike price is $650 and the stock is trading at $700. This difference is the intrinsic value. The other value in any option is its “time value”. In this case the time value will be zero as there is practically no time left before options expiration. So, we end up making five times our original investment. However, the second possibility in this scenario is that GOOG may not fully live up to the expectations and the stock trades at less than $650 after the earnings release. Here again, our options will become worthless.
When one reviews the three scenarios, it is easy to see why we like the second scenario the most. It has the best combination of leverage and risk management. Sure, one may leave some gains on the table. But the important thing is one does take in the gains.
