My motivation and mission:
Google sheet that contains list of all WCD lessons and links to all content:
Lesson reviewing how to use Google sheet:
My Stance on Options & Robinhood
I was going to save this post for a much later date as derivatives and options are a complicated subject, but I think it’s important to discuss because there are several investing related social media groups with large followings that promote the use of options (e.g. r/wallstreetbets).
I was actually an early subscriber to: https://www.reddit.com/r/wallstreetbets/
I loved the Memes and found a lot of entertainment from lurking and seeing what all the degenerates were posting about.
I was able to turn $14k into about $45k in less than a year of experimenting with options trading. As you can see, my returns have been rather lumpy.
What separates me from a lot of the people on r/wsb? I was only messing around with 1-2% of my portfolio. There were a couple times when I put 100% of my Robinhood account into out of the money call options on just one stock… but this was only a small percentage of my entire portfolio. I have a separate Fidelity account and treat this account very differently than my Robinhood account.
I do think it’s good to learn how options and derivatives work. It’s a great tool to have in your financial tool belt.
Options can increase your overall returns and can be utilized to help manage risk if used correctly.
I’m by no means an expert options trader. I use my Robinhood account and options as a way to “scratch an activity itch.” Sometimes the best thing to do in investing is to do nothing and sometimes this is the hardest thing to do.
Robinhood and options are a great dopamine hit and so far I have been lucky enough to be more right that wrong. I would advise anyone who is just starting out with investing to avoid options for the first few years, but if you must, then only use 1-5% of your portfolio for options and keep them in a separate brokerage account from your main brokerage account.
Keep reading to actually learn the fundamentals about derivatives and options.
Derivatives
The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark.
In the case of stock options:
The underlying asset is the stock price
The options contract is the derivative
Options
Options are a derivative contract that give you the right to buy or sell an underlying security at a defined strike price at a given time. The price of the option will move based on the price movements of the underlying security.
The closer the option is to expiring, the faster the price of the option can move (e.g. short duration options will have a lot more volatility than long duration options).
An aspect of options that I found confusing is that you can buy or sell options. As investors, we typically think from the “buy side” because due to SEC regulations, we are not allowed to write new options contracts (aka “sell to open”). We can sell an options contract if we have already purchased it (“sell to close”), but we can not “sell to open.”
As investors on the “buy side”, this is what we have the ability to do:
Buy to open - Buy a put/call option to open a new position
Sell to close - Sell a put/call option to close an existing position
The big “market makers” have the ability to:
Sell to open - Sell new put/call options in order to hedge risk
Buy to close - Buy existing put/call options to close options they wrote (reduce risk exposure by reducing number of open options they have if the price starts going in the opposite direction)
I think examples of the profit and loss (P&L) are the easiest way to learn options.
Profit and Loss
Buy Call Option
The is the simplest option to understand. You make money if the underlying stock increases past the strike price. You potentially have unlimited gains if the stock price continues to rise (hence the popularity by retail investors).
Stock = $100
Strike = $110
Option Price = $10
Breakeven = Strike + Price = $110 + $10 = $120
You make money if the price rises above $120
You have unlimited upside if the price continues to rise
You have a maximum downside of losing your initial investment of $10 X 100 = $1,000
Sell Call Option (only market makers can sell naked options like this)
This has unlimited downside risk if the stock price continues to rise. This is only practical to use in combination with other positions to hedge risk (such as covered calls).
Stock = $100
Strike = $110
Option Price = $10
Breakeven = Strike + Price = $110 + $10 = $120
You make money if the share price drops below $120
Maximum gain of $10 x 100 = $1,000
You have an infinite loss if the stock price continues to rise past breakeven price!!!!!
Buy Put Option
This is the second easiest option to understand. You are betting the stock goes down. This is my preferred method of betting a stock is going to go down (as opposed to doing a naked short which has unlimited loss if the stock continues to rise). Buying a put option has a limited loss of the initial purchase price.
Stock = $100
Strike = $90
Option Price = $10
Breakeven = Strike - Price = $90 - $10 = $80
You make money if the stock price drops below $80
You have a limited upside if the price continues to drop below strike ($8000)
You have a maximum downside of losing your initial investment of $10 X 100 = $1,000
Sell Put Option (only market makers can sell naked options like this)
Stock = $100
Strike = $90
Option Price = $10
Breakeven = Strike - Price = $90 - $10 = $80
You make money if the stock price rises above $80
You have a maximum upside of the principal you sold of $10 X 100 = $1,000
You have a limited downside if the price continues to drop below strike ($8000)
Buy Covered Call (Long the stock, sell call option)
This is a strategy where you own the stock and sell call options against the shares that you already own. (sell 1 call option for each 100x shares you own).
The strategy is basically betting that the stock will rise… but not rise too fast.
You obtain extra premium from selling the call options and you make extra money as long as the stock price stays under the strike price of the call option you sell.
If the stock price rises above the strike price, then you would have been better off just owning the stock.
In example below, the call option you are selling has a strike of $110, so as long as the stock price stays below $110, then you make more money from this strategy then simply owning the stock.
This is a strategy savvy, retired people with large 401Ks could use to obtain cash flow.
Blue = Long stock
Orange = Sell Call
Below is the combination of the long stock and sell call option strategy
Terminology
Here is some of the language you will need to understand:
In-The-Money (ITM)
This means than the stock price is within the strike price of the options contract.
Example 1 - A call option with strike price of $100 and the stock price is $110.
Example 2 - A put option with strike price of $100 and the stock price is $90.
These are less risky, but the premiums will be higher.
If an option expires ITM, it retains some value.
Out-Of-The-Money (OTM)
This means than the stock price is within the strike price of the options contract.
Example 1 - A call option with strike price of $100 and the stock price is $50.
Example 2 - A put option with strike price of $100 and the stock price is $200.
These are more risky, as the stock needs to move a long way before you even reach the strike price. The premium will be low, but the probability of the option expiring ITM is low.
If an option expire OTM, then it expires worthless.
Options - The Greeks
YouTube Video I found helpful:
Delta
Probability option expires ITM
The amount the option price will move if the underlying stock moves $1
Gamma
Rate of change of Delta
“Convexity”
Theta
Time decay Greek
How much the option price will decay each day (buyers lose money, sellers make money)
Vega
Implied volatility
Increased volatility will increase premium. This impacts long-term expiration options more. (The premium on short-term options is controlled more by delta).
If you buy a long-term out of the money call option, and you get a random spike in price, you will see a large spike in premium that might decay if the stock price stays flat (this is due to the volatility dampening). The random spike in price drove up the Vega, but once the volatility wears off, the premium will come back down.
Rho
How much the premium will change based on interest rates
Nobody really cares about Rho
Summary
Options are complicated. The best way to learn anything is to do it. I learned options by making and losing money trading them on Robinhood. So far, I’m up about 200%.
However, do not use 100% of your portfolio on options. If you are going to use options, save them for a very small percentage of your portfolio (<5%) and start small.
Here is my practical advice for how to best use options as a retail investor:
Never use more than 5% of your portfolio on options.
Buy deep in-the-money (ITM) and long-expiration call options (LEAPs) on stocks that you have the greatest conviction on increasing over the next 1-2 years. This can provide a little extra “juice” to your portfolio if you are right.
Never short a stock. Instead, buy a put option instead to mitigate unlimited downside risk.
There is little value in buying out-of-the-money (OTM) puts options. There isn’t enough upside on put options to take this risk.
If you can’t resist buying out-of-the-money (OTM) options, then stick to call options as the upside return can potentially be much much larger.
Call options are a good strategy if the stock has exponential traits. Things like network effects are examples of exponential growth. If the business grows exponentially, then there is a chance that the option is underpriced in the long-term.
Reference Material & Social Media
In Lesson 030 I cover how to navigate and utilize the Google Sheet I have built for all WCD lessons. This Google Sheet contains a worksheet for each WCD lesson. Each sheet has all of the Excel calculations, tables, graphs, and charts that I have posted in the respective WCD lesson. Additionally, the Google Sheet has a master “Index” worksheet that has links to all of the content associated with each lesson.
If you found this post helpful, please like, share, and follow me on my social media channels!