Editor's note: This is an excerpt from Michael's book The Power of Options. To get the entire book – free, with no strings attached – go here.
Introduction: The Power of Options
If you feel like Alice, lost in Wonderland, when you start to explore options, you're not alone.
So many traders and teachers and even so-called "experts" struggle with options. It gets even uglier when they attempt to bring it down to earth for their readers.
Yet that's just what Money Map Press Publisher Mike Ward has asked me to do for you. My job in this book is to show you the beauty of options – that part will be easy – and then demonstrate how these trades work.
If anyone can do it, I can. I have written six books about options, and probably more importantly, I have been trading options myself for more than 35 years (meaning I have already made every possible mistake you can make).
Here's my promise to you.
I promise to make everything as clear I can, and to keep it as simple as possible. I'll show you how to open an options account in a matter of minutes, so you can get your options trading career off the ground as painlessly as possible. Then I'll help you expand your vocabulary so you can talk options. Next, I will show you some easy techniques, and a few more complicated ones. You can start off paper-trading them to get the hang of it, or you can jump right in.
Finally, I'll show you how Money Map's expert editors, including Keith Fitz-Gerald, Martin Hutchinson, Peter Krauth, Shah Gilani, and Kent Moors, have made real money for their VIP Subscribers.
The Power of Options… to Juice Up Your Profits
Done right, options can create a cash cow in your portfolio – often quickly, and often at considerable levels. Consider the case of the SPDR Gold Trust (NYSEArca: GLD).
A year ago, GLD shares were trading for about $130.
Say you felt pretty confident GLD was going to go up in the next 12 months. You could have gone "long" GLD by buying 100 shares. You'd have to be ready to plunk down $13,000 for them, but let's say you happened to have the cash on hand. You'd have done pretty well; 12 months later, GLD was trading at $160, and your 100 GLD shares were worth $16,000. That's a nice 23.7% gain.
Or you could have used options.
Let's say, instead, you bought one $135 call. (A "call" is just a bet on the price of GLD going up from $130; the same thing you're betting on when you buy the stock.)
A year ago, the call was trading at $9.00. So you would have spent about $900. (I'll explain why shortly.) Yet by the expiration month, the price had risen to $28.00, so that option "contract" you bought was worth $2,800. That's more than a 300% gain on the very same price move of GLD.
And there's more.
The Power of Options… to Manage Your Portfolio
Options are amazing, versatile tools. They can be very speculative and high-risk and give you spectacular returns. On the other end of the spectrum, they can be very conservative, produce consistent double-digit returns, and serve as tools for portfolio management.
Here's what I mean by "portfolio management." You can apply option strategies to a traditional portfolio of "long" stock positions – remember, those are stocks you own because you expect them to go up in price – to manage, reduce, and even eliminate risks.
For example, you can buy puts to play a bear market. This means you can avoid the high risks of shorting a stock (because you are "long" the puts), yet still profit from a falling market (even while everyone else sings the blues). There is just no other way to do this so safely.
Risk management has become one of the most exciting uses of options, as well as the focus of much of the huge increase in options trading in recent years. Because truly, this is a huge trend.
Don't Miss the Options Party
By now, you're probably starting to see how – and why – traders use options. You can be a part of it. All you need is some good information (you're looking at it), a short learning curve, and a sense of where the market is heading.
The option market is not as isolated as you might think, nor is it some exclusive club for the experienced high-risk trader. Options have become mainstream.
To get an idea of how the market has grown since its beginnings in the early 1970s, take a look at this table.
Today, options are being traded on hundreds of stocks, ETFs, and indices. No longer are they viewed as exotic, high-risk, and impossible to understand. And there is no reason that you should not be grabbing your share of those profits.
In the pioneer days of options, back in 1973, you could buy a call option on one of 16 publicly traded companies. Puts – the other side of the coin; a bet that a stock will fall – weren't available at all.
I remember my first exposure to options, in the late 1970s. I was working in San Francisco as an accountant, and one of my friends told me I should sell options. He explained it like this:
"You own 100 shares and you sell a call. You get the money right away and you keep it no matter what. It could get exercised and your stock sold, but most of the time the call expires. Then you can sell another one."
This, in a nutshell, is how "covered call writing" works, and to this day it remains one of the most popular – and profitable – strategies. But when I first heard about it, I wasn't buying it.
So you can sell something, get the money, and wait for it to expire; then do it again? How could you sell something you didn't own? That's exactly where a lot of traders find themselves when they first hear about options. It's a journey from there to a full understanding. But the journey isn't as long or as difficult as you might think.
Of course, some people are too close-minded to take the leap and try something new, no matter how powerful a tool. That's their loss.
With the help of our experts to guide you through the option maze, you could easily find yourself trading options – and making money – very soon. Read on. I am going to walk you through the basics of option trading. (And we'll leave the White Rabbit behind.)
Chapter 1 – Getting Started
Here it is. The most important piece of advice I have for anyone thinking about trading options.
Don't let the red tape hold you back.
A lot of experienced and sophisticated investors shy away from anything that involves paperwork. They think they're not qualified or not ready, or simply that it's not worth the trouble. Don't be one of them.
Yes, you will have to fill out an options application with your broker, but it's easy. You had to file a similar form just to open a trading account in the first place. Now, if you want to upgrade your account to "options approved," it's just a small step away.
The application may look intimidating at first glance. It is full of disclosures and legal qualifications. Yet the purpose is simple enough. Your broker just wants you to state that you know enough about options to make your own trading decisions.
And not to worry… It's not a quiz.
The disclosures will gauge your level of experience, but their real goal is to let the brokerage firm off the hook in case things go terribly wrong. (Of course, that's not going to happen to you.) If a broker lets anyone trade without at least appearing to check them out first, they could be liable for your losses. And no one wants that.
Because options are by definition speculative, the New York Stock Exchange (NYSE), Financial Industry Regulatory Authority (FINRA), and National Association of Securities Dealers (NASD) all have rules and policies about "suitability." That's the real reason you have to go through this (very small) hoop.
So you'll fill out the application… they'll file it away into the "just in case" drawer… and everyone's happy.
What's on the Application
The option application will ask some questions you would expect: Name, address, employment and employer name, annual income and all sources of income. They also want to know your net worth and liquid net worth, marital status and number of dependents.
Then there are a few questions you might not expect.
Like about your "affiliations." Are you a member of a stock exchange, or do you hold 10% or more in stock of any publicly traded companies? Most likely not. You will also be asked to identify both your stock trading and option trading experience: Knowledge level, number of years actively trading, average number of trades per year, and the average dollar amount of trades.
So the application has a few surprises, but nothing difficult to complete.
The biggest time-consumer is the pages of disclosures and qualifiers, about option trading risks, margin accounts, and financing disclosures – all of which you are required to acknowledge and sign off on.
Once you send in the application, the brokerage reviews it and assigns you to an "options approval" level. The level defines your ability to take risks based on knowledge levels and experience. While terminology varies among brokerage firms, there are always four levels:
- Level 0 — At this basic level, you are not allowed to do very much. You can write covered calls and protective puts, and not much more.
- Level 1 — You can do everything in level 0, plus buy calls or puts and open long straddles and strangles.
- Level 2 — Now you're getting somewhere! Here you can do everything in the previous two levels, plus open long spreads and long-side ratio spreads. (And no, there is no VIP lounge or mileage bonus for getting to this level.)
- Level 3 — This is for the big dogs. At this level, you can enter into just about any kind of options positions. This includes all of the other level trades, plus uncovered options, short straddles and strangles, and uncovered ratio spreads.
Your broker is going to assign a level to your options account based on what you say on the application, and (although they don't tell you this) based on the amount of cash you put into your account when you open it. You need at least $5,000 to trade on "margin" (and option trading requires a margin account), and the more you start out with, the better your chances for landing in the higher levels.
Remember, this is all designed to cover the brokerage risks of letting you trade options. The higher the level, the higher your risks. But remember, the higher your level, the higher their risks – especially if you lose a lot of money and then hire a lawyer to sue, claiming you didn't know what you were doing.
Now, is your brokerage firm actually going to investigate your claims about knowledge and experience levels? Probably not. But again, they do want you to fill out the form so they cannot be held responsible, just in case your lawyer later tries to claim you were allowed to trade above your experience level. Should it ever go to trial, the application is potentially your broker's "Exhibit A." It is designed to make sure they don't lose that lawsuit.
So, just like that, we're ready to trade options.
Let's start by nailing down a few simple concepts.
Editor's note: This is an excerpt from Michael's book The Power of Options, a free gift to Money Morning readers. To get your copy (again, it's free – no strings attached), go here.