Editor's note: With anything in life, you must master the basics before you can move on to more advanced lessons. In today's Weekend Edition, our colleague and Retirement Trader editor Dr. David Eifrig explains that the way we learn to do everyday tasks is a lot like how you should approach one trading tool that many folks avoid using at all costs...
Cognitive psychologists have named the way we learn "chunking"...
When you want to internalize and understand a new concept with multiple moving parts, you break it into pieces, or "chunks." Most research shows we can handle about four or five chunks.
You juggle these concepts around in your head while you think about a problem. Eventually those chunks fuse into a single idea that you understand. Now you can layer that singular "chunk" with others to form a deeper and more rewarding concept.
By doing that, you can act in a way that feels like you're not even thinking about it, even though you may be applying a complicated thought process.
Here's an example that resonates with me. When you're first learning to drive, you have to run through a checklist to back your car out of the driveway...
- Start the car.
- Put on your seatbelt.
- Check the rearview mirror.
- Put the car in reverse.
- Start slowly.
- Turn the wheel.
And so on. For your first few times, you think about every one of those steps. You keep the radio off or pause your conversation with your passenger while you focus on the task at hand.
Eventually, though, this all becomes one thought to you...
The six-step checklist blurs into a single concept: "Pull out of the driveway." You can perform this multistep task, process multiple sensory inputs, and pilot a 3,000-pound vehicle out onto the road. Even if you're in an unfamiliar place or in a hurry, it all happens automatically.
The same thing happens with options...
I've taught thousands of people how to trade options through my writing, and dozens – if not hundreds – of people personally. I've seen it happen all the time.
Options seem difficult or confusing. They are a foreign concept. A new way of thinking. But before long, the concepts lock in place...
I would never claim that options are easy in the sense that everyone should understand them right away... But they are easy in the sense that anyone given a little time can process these into one chunk.
We all start out worried that we'll scrape out over the curb... but before long, backing out is second nature.
My goal is to get you past the options basics so you can start applying them to your own trading...
Eventually, you should be able to chunk even the most complicated options trade into a simple, easy-to-understand thought. But to get there, you first need to understand how options work and how you can use them to maximize your gains.
So let's start at the top...
An option is simply a contract that you enter into with another person.
The value, or "payout," of the contract is derived from the price of a stock. (That's why options are classified as a type of "derivative.")
Now, I doubt many of the folks reading this essay are contract lawyers. So it's important to note that these contracts are standardized. There's no negotiating over the terms or conditions. They're all the same. That allows them to be traded quickly in the options market.
So we're dealing with contracts, but we can buy and sell them with ease at the prevailing market price.
Options come in two main varieties: calls and puts. And you can either buy or sell them.
Let's talk about buying and selling first...
These terms often cause confusion because people think of buying and selling stock. In the case of a stock, you need to own it to sell it. Options aren't like that. You can sell one that you don't already own.
Remember, though, that options aren't stocks. They are contracts. When we say, "sell an option," you can interchangeably use the phrase "write an option."
In other words, if you want to sell an option you don't own, you are really writing a new contract and putting it up for sale.
Let's move on to the difference between call and put options...
A call option represents the right to buy a stock at a specified price in the future. A put option represents the right to sell a stock for a specified price.
To me, the most intuitive example is buying a put. Put buyers use them as a hedge or as insurance on a stock. That makes it an easy example to get your head around.
Let's say you own stock in a company whose shares trade for $100. You like the company and think its shares will go up. But you know stocks can be unpredictable. Rather than stand fully exposed to the downside, you can buy a put to hedge your investment.
You could buy a put with a "strike price" of $90. And it will cost you $5 (per share).
Buying the put gives you the right to sell your shares for $90 each, no matter how low the stock's price may fall on the open market. Someone out there sold the put to you, so he's got the other side of the trade.
If the stock stays at $100, you have the right to sell it for $90 to the other guy... though you wouldn't do it. $100 is more than $90. If you wanted to sell shares, you'd just do it in the open market.
That's what we mean when we say the buyer of the put has the right, but not the obligation, to sell those shares. He literally holds the option to sell. If you want to keep your shares, you can. However, the other guy – the option seller – has the obligation. If you (the option buyer) say so, he has to pony up $90 per share.
However, if the company's shares trade for $80, you still get to sell it for $90. You can "exercise" your put. The other guy pays you $90, and he takes your shares. After considering your $5 upfront cost, you are $5 better off than if you held an unhedged position.
If it trades for $50... it doesn't matter. You still get to sell it to the other guy for $90. You've just protected your wealth and the other guy tried to make a $5-a-share profit but ended up losing $35 a share.
Buying a put as insurance is just like the insurance you buy on your home. If your home burns down and it's worth practically nothing, the insurance company will give you a check for a certain value. For this certainty, you pay a small amount in insurance premiums.
To summarize, the put buyer gets protection on his position. He has a floor on his share price. And he has to pay some dollar amount up front, which we call a premium.
The put seller, on the other hand, gets to collect that premium as income. But he must stand ready to buy shares at the agreed-upon price. If the stock doesn't fall, he gets to keep the premium free and clear.
If put options make sense as insurance and hedging, call options work for speculation.
A call buyer has the right to buy shares for a certain price. The call seller must provide those shares at the agreed-upon price.
Let's look at the call buyer here. You look at a stock trading at $100 a share. You don't own any, but you think shares are going to go up to $110.
If you're right, you could buy shares and earn a 10% return.
But you could buy a call option instead. You may pay $2 for an option with a $105 strike price. This means that no matter what may happen in the market, you can buy shares for $105.
If shares rise to $110 like you expect, you can "exercise" your call and buy shares for $105 each. You can immediately sell them in the market for $110. You've made a $5-per-share profit. Considering you paid $2 to buy the option at the start, you've turned $2 into $5. A return of 150% on the same move in the stock.
However, if the stock never trades for more than $105 a share, your option won't be worth anything. You wouldn't exercise your option and pay $105 for shares that trade at $105. Considering that you already paid $2, you need shares to rise to $107 to break even.
Can you see the benefit for the call seller? He collects $2 up front. Depending on where share prices end, there's a good chance he'll keep it free and clear.
With just these simple option trades, we've got four different bets traders can make...
This table makes it easy to see what sort of bet an option trader is making. A call buyer is bullish on the stock, is paying for the right to buy shares, and has unlimited upside. His downside is limited because he can't lose any more than what he pays out in premiums.
A put buyer, on the other hand, is bearish. He has the right (but not the obligation) to sell shares. The put buyer can't lose more than the initial premium he pays, so the downside is limited.
The more a stock falls, the higher the profits for a put buyer. Since stocks can't drop below $0, the upside is technically limited. However, as you dig deeper, you'll see that the upside outpaces the downside many times over. Effectively, we can call the upside "unlimited."
Looking at these potential payoffs, it looks like option buyers with their unlimited upside and limited downside would make for the best trades. After all, who wants to try and capture a limited upside with unlimited downside.
You'll see, though, that option selling tends to have a much higher success rate. And if used properly, you can curtail the risks to acceptable levels. You can turn option selling into a reliable stream of income.
Option buying allows you to earn big gains, but you have to properly predict big moves in stocks within a specific time frame. That's hard to do. So you may win bigger, but you'll win less often.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: Dave recently showed a 66-year-old retired police chief with no investment experience how to use options to make $1,000 in just 15 minutes. We filmed the entire trade – from start to finish – so you can see exactly how his powerful strategy works... and why it has a 95% success rate since 2010. Watch the full presentation right here.