In today’s article, I want to answer a few questions about why options can be dangerous. What are the risks of options trading? Are puts or calls riskier? Why is option selling risky? We’ll also talk about the safest options trading strategy.
Let’s get started.
Buying Calls & Puts
First of all, you need to understand that there are different types of options. There are call options and put options. So calls versus puts, which one is riskier? Some people think that trading puts are riskier, while some people might think that trading calls are riskier, but this is not the case at all.
The key question that you should ask yourself is, are you BUYING options or are you SELLING options? There’s a huge difference between buying and selling, as well as different levels of risk involved between the two.
When you’re buying options, the maximum amount you can lose is the premium you paid. Let me show you a very specific example. Let’s look at TSLA, and let’s say that we want to trade a call. So let’s maybe say a 700 call, and right now the price is $700. What is the maximum that you can lose?
Let’s say that we are bullish on Tesla and we believe that Tesla might go above $750, and we want to buy a call with a strike price of 750. So a 750 strike call expiring next week costs around $1.70 (at the time of writing this article on March 19th, 2021).
Now, options come in 100 packs, so this means that you’re paying $170 for this option. So in this case, if Tesla does not go above 170 by next Friday, you would lose the $170. So this is very easy, the maximum amount that you can lose is the premium that you paid.
On the other hand, you are bearish on Tesla. You believe that it might go down to $560 so you’re thinking about a put option with a strike price of 560 that expires next week.
A put with a 560 strike price expiring next week is $4.50, so a little bit pricier here. Again, since options come in 100 packs, this means that your total risk here is $450 per option traded.
It’s the same risk here because it doesn’t really matter whether you’re buying calls or you’re buying puts. The maximum amount that you can lose is the premium.
Now, on the other hand, there is SELLING options, and when you’re selling options, this is when your risk is almost unlimited. When you’re buying options, and let’s just say you want to buy a call, this means that you want the stock to go up.
Going back to our TSLA example, if we would buy a call 750 that’s expiring next week for $170, if Tesla goes above 750 we make money. If Tesla goes below 750 or stays at 750, we lose the premium or $170. Not really a big deal.
Now, how much money could we make on this one? Well, if we buy a call for 750, we have the right to buy 100 shares of Tesla for $750. So let’s say that Tesla closes at $800.
In this case our profit is $800 minus the $750 that we bought Tesla for, which is $50 per share. Since options come in 100 packs, this means that we would make $5,000 in profits. This is why people love trading options. Because if you think about it, we’re risking $170 and can potentially make $5,000 if Tesla would go up to $800.
Now, let’s quickly do an example here for buying a put. Here you want the stock to go down. Using our example for Tesla again, we will buy a put with the strike price of 560 for $4.50, making our total risk $450.
So now if Tesla goes below $560, the strike price, we make money. If Tesla stays above 560, we lose the premium. But that is the maximum that we can lose. So even if Tesla rallies right now to 800, we would only lose $450. Pretty cool, right?
Let’s say Tesla goes to $500. We were able to sell the shares for $560, now we can buy it back for $500. This would be $60 per share. Since one option equals 100 shares, it means that we would make $6,000 in profits.
As you can see, with options you can benefit from a stock going up, as well as a stock going down. The really cool thing is that you can risk a little to make a whole lot.
Now, here’s the challenge with this. If you buy a call, you only make money if Tesla is really going above $750. If it stays below, that’s not enough for the buyer of an option to make money. If Tesla goes sideways, then you not only won’t benefit from it, but you also lose the premium. If Tesla goes down, you also lose the premium.
So if you think about it, there’s actually three ways how you can lose money and only one way how you can make money, and this is if Tesla really shoots up. This is why many people, including myself, are interested in SELLING options.
Selling Calls & Puts
What are the pros of selling options? The first pro is that you don’t need to be right about the direction of a stock to make money.
Here is an example I’m in right now (at the time of this writing on March 19th, 2021) with (LL) Lumber Liquidators.
Here I sold a put with a strike price of 22.
When does the buyer of a put make money? Well, the buyer of a put makes money if it goes below $22. For me, the seller of a put, I make money if Lumber Liquidators goes up, sideways, or down. It can go down all the way to 22. This is a drop of a little over 10%.
If you think about it, if Lumber Liquidators can go down by 10% and I’m still making money, this is what makes selling options so fascinating. You don’t need to be right about the direction and you can keep the premium.
Now, here’s the deal. The premium that you receive is exactly what the buyer is giving you. The premium is rather small, right? So the cons are the premium is rather small, and this is where your risk is almost unlimited.
Back to our example here with Lumber Liquidators. I sold 45 of the 22 puts, and I received $0.20 per share, $20 per put option. $20 multiplied by the 45 options means that I’m making $900. This is the premium that I receive.
However, here’s the deal. The buyer of a put has the right to sell 100 shares at the strike price. What does this mean for me? The seller, which is me, has to buy Lumber Liquidator at $22, and again, this is where one option means 100 shares. So for me here, since I have 45 options, this means that I would have to buy 4,500 shares.
This is where we get to the risks of this strategy. Now, again, Lumber Liquidators can drop more than 10% and I will be just fine. But what happens if it drops below, let’s say to $20 from $22? I would have to buy Lumber Liquidators at $22, and therefore I would lose $2 per share. Here, in this case, I have 4,500 shares times $2, this means that I would lose $9,000.
Now you get the idea of why selling options is fairly risky, because I’m receiving $900, but if it only goes down by $2, I’m already losing $9,000. But what if it gets worse? What if LL drops to, let’s say, $15, right? Again, I have to buy LL at 22, so I would lose $22 minus $15, $7 per share.
Since I have 4,500 shares, times $7, this is where I would lose $31,500. As you can see, it is super risky if you don’t know what you’re doing. I have been selling premium for a long time, and I’ve been doing really, really well.
Analyzing Risk With RIDE
Let talk about a particular trade that I made with RIDE. I sold the 21.50 put and RIDE dropped. I sold 47 contracts, which means that I own 4,700 shares at a price of 21.50.
RIDE right now (March 19th, 2021) is trading at $13.50. This means that I lose (21.50, minus 13.50) $8. So I’m losing $8 per share and I’m having 4,700 shares, bringing me down to a total of $37,600.
Now, let’s talk about it. How much money did I make selling premium on RIDE? I sold the puts initially, then I sold calls, and I just sold a few more puts. In total on RIDE, thus far, I collected $4,935 in premium, but I also have an unrealized loss of $37,600.
It’s super important that you understand that there is risk involved. I know my way out of this. I know how I can trade my way out of this if needed.
So I collected $4,900, but right now I’m down that amount. However, this means that my net loss is, if I would close it right now, which I’m not intending to do, would be $37,000 minus the $4,935, let’s just say $5,000 to make the math easy, is $32,600. That would be a real loss.
This is why it’s super important that you understand the risks when you’re trading options.
Safest Options Trading Strategy
One of the questions that I receive all the time is, “What is the safest options trading strategy?” The safest options trading strategy is covered calls, and here’s why.
When you’re trading covered calls, it means you own the stock, and now you are selling calls against it. So what does it mean when you are selling calls? When you are selling calls, it means you have to sell the stock at a certain price.
Back to my example with RIDE, I own 4,700 shares, and I own those at $21.50. This is where if I sell calls at 22.50, this means that I have to sell RIDE shares at $22.50.
How much money do I make? I bought at $21.50, and I sell at $22.50, so this means that I’m making a dollar profit, $1 profit per share. And since I have 4,700 shares I would make $4,700 plus the premium I receive for selling the call.
This is is in addition, and therefore, covered calls are by far the safest options trading strategy.
The only way you can lose with this strategy is when the stock goes down. This is where you already own the stock, and therefore, if you want to sell calls against it, it is the safest option trading strategy, at least based on my experience and my opinion.