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How To Trade Options For Beginners: The Easy Way

 

Why do I trade options?

 

It’s simple, really. I trade options under two scenarios:

  1. I own a stock and don’t mind selling it (at a given price)
  2. I don’t own a stock and wouldn’t mind buying it (at a given price)

In the meantime, while I’m not buying or selling stocks (this should happen 90% of the time; for me, to date, I’m at a 100% success rate), I’m collecting premiums of a few hundred dollars per sale.

Scenario one is a Call option. Scenario two is a Put option. We’ll go over both in this beginner’s guide to options trading.

Think of it like this.

To make a Call, you have to pick up your phone. Or, you are betting that the price won’t go up.

You will Put down your phone to end the conversation. Or, you are betting that the price won’t go down.

Meet Roy

 

The year is 2016. I had been fired twice in the past 12 months and I had just started my Airbnb property management company, where Roy was one of my first clients.

Roy owned a mansion in the Bay Area, which I rented out for $1,500 per night. Roy was also fabulously wealthy from owning gas stations.

I can’t remember how the topic came up, but he offered to teach me how to trade options. I took him up on this offer at once. I was genuinely interested. I had been investing since 2008. I brought my friend Collin along for one of the sessions.

Roy taught me how to trade options from his “funny money” account, as he called it, which had a $9,000,000 balance.

I will teach you the same simple options trading strategy that Roy taught me.

Let’s get started.

Roy’s Options Trading Strategy: Selling Puts

 

Roy told me that he had two rules for options trading.

Rule #1: Don’t lose money.

Rule #2: See rule #1.

I later realized these rules were borrowed from Warren Buffet. Roy was my real-life Warren Buffet.

Essentially, what those rules translate to is a very conservative options trading strategy. There are options traders making a higher ROI with a riskier strategy, but this was not Roy’s way. I like Roy’s strategy.

Roy explained his options trading strategy as picking up pennies off a train track.

In this section, we will Sell to Open a Put option.

What that means is that you are giving someone the option to sell their shares to you at a given price (below the current stock price). It’s a sort of insurance for the buyer. You are the seller.

Example: I Sell to Open a Put option on TSLA stock (current stock price: $185) at $165. This would mean that someone is going to pay me a small premium to guarantee that they can sell me 100 shares (selling one option contract equals 100 shares) of their TSLA stock at $165, no matter what the real stock price is. Even if the stock price went down to $150, if the option is exercised, I would have to buy 100 shares at $165 for a total of $16,500. Now, I do own TSLA shares in this scenario, so not all is lost. However, I am in the hole, in this (avoidable) scenario $1,500 (100 shares * buying the stock at $15 above current share price).

The first and most important concept I want to introduce you to is the Delta.

Delta represents the probability that an options contract is “in the money.” In our example above, the options contract would have been “in the money” as soon as the stock price fell below $165.

Any trading platform (Charles Schwab, Robinhood, Fidelity, etc.) will show you the Delta.

Options Trading Strategy Key: Sell to Open a Put with a Delta of 0.10 or less. This would mean that there’s a 90% chance of the options contract expiring “out of the money.” Ninety percent of the time you would collect the premium, end of story.

What does it mean for an options contract to expire? When you Sell to Open a Put, you will need to choose a date for expiry. The date is always on Friday and in the future. The further the expiry date, the higher the premium, but the riskier the options trade.

Congrats! I think you know enough to go through a real-life example.

But, if you’ve had enough, I created a video for you. I also do passive investing, and I share my favorite online investing platforms:

 

Selling a Call Options Example

 

I am going to Sell to Open a Put on TSLA.

Date: Monday, May 13

Current Stock Price: $168

I will have to choose my strike price. The strike price simply represents the price at which I will buy shares of TSLA if the options contract is in the money before expiry.

But don’t worry. Our Delta, in relation to the expiry date, will tell us what strike price we want.

For expiry this Friday, May 17 and a strike price of $165, the Delta is 0.32. That’s too risky for our beginner’s options trading strategy. Remember, the trading platform will show you this number. There’s no calculating you need to do. All platforms will calculate to the same Delta number.

What about a strike price of $160? The trading platform says the Delta is 0.18. Still too high/risky.

At a strike price of $155, the Delta is 0.09. Perfect.

We will Sell to Open one Put option on TSLA on Monday, May 13, with a strike price of $155 and an expiration date of May 19. The premium that immediately gets deposited into your trading account upon the sale of this option is $39.

That might not sound like much, but hold out for me until we calculate the return. You need to do this for any investing activity to judge its worthwhileness.

There are two scenarios that will play out over the next five days until the expiration date.

First, is that May 17th will pass with the TSLA stock price above $155, and nothing will happen. We collected our premium. The option expired. We can sell another option next Monday, if we want to.

Second, if the TSLA price drops below $155 before expiration, the option is executed, and we now need to pay for and own 100 shares of TSLA stock.

By the way, if you changed your mind and did not want to own TSLA shares, there is a simple strategy to “roll” your options contact forward a week or close it out early, but I’m deeming that too advanced for this beginner’s options trading guide.

Please let me know in the comment section if you want me to cover how to “roll” an options contract.

How To Calculate Your Return on Selling Put Options

 

There are many formulas for calculating your return on options selling, but I’m going to share the most straightforward one.

Essentially, we are measuring how much we earned compared to how much we risked given the time period.

Let’s keep with our example above. Remember: premium received / cash risked or needed to purchase stock.

In this case, we received $39 and risked $15,500 (1 options contract * 100 shares * $155 strike price). So $39 / $15,500 = 0.25%.

However, we earned this return in only five days, so we have to take that into account. If we did this same trade every week this year, what would be our annual return?

To get that, we would multiply by 52 weeks. So, 0.25% * 52 weeks = 13.1% annual return.

In general, you want a higher return for a riskier investing activity. Typical investors are very happy with 10% returns. So a 13.1% return for a few minutes of your time is excellent.

If that doesn’t make sense, post your question or clarification in the comments. See you there.

There is a slight variation to the formula if you are making trades lasting more than one week. As it makes things a little more complicated, I’m going to leave it out of this blog post, but if you happen to be interested, again, tell me in the comments, and I’ll share the options ROI formula there.

easy beginner options trading guide strategy

My Easy Covered Call Options Strategy

 

A covered call is a strategy used when you own 100 or more shares of a stock and would be happy to sell at a given price.

Important Note: Selling a Call on a stock that you do not own is called a Naked Call and is extremely risk. I do not advise it.

Let me give you a real-life scenario. I own 500 shares of ABNB (Airbnb). I want to sell my ABNB because the company is no longer promising. In the time that I owned the stock, it’s been as high as $212. Over the past couple years, the stock has been annoyingly steady. Over the past two years, it has almost always stayed below $150.

 

You can see that over the past five years, the stock has increased a measly 5.08%.

This puts me in a predicament. I own the shares, and I want to sell them, but at a slightly higher price than the current stock price. I’m in no rush to sell the shares, but I don’t believe the company is well-managed, so I don’t see the price going higher in the future. I also don’t see the company going out of business anytime soon. Also, the stock price is extremely consistent, which affects Volatility, another measure I will introduce shortly.

In this case, I am going to sell five Covered Call options contracts because I have 500 shares that I’m willing to sell. I am going to choose a strike price at whatever I’m comfortable selling the price at, given the return.

In this case, I know the price has barely ever breached $150 and never $165 over the past 24 months. I decided I’d be happy to sell at $165 so that will be my strike price.

In this case, the strike price represents at what price I will sell my shares to whoever buys my Call option, no matter how high the stock price rises.

The only other thing I have to choose is an expiration date. Let’s run through an example.

Same date: May 13th. I am going to Sell to Open five Covered Call options contracts with a strike price of $165.

If I choose this Friday, May 17, the trading platform tells me I’ll earn a premium of $19. You can decide for yourself, but this is not worth my time.

For reference, the Delta on this trade is 0.004.

The expiration date of May 24th yields a premium of $38. Still, not enough.

Let’s go to June 28th. Remember, over the past two years, the stock has never gotten to $165, which is why the premiums are so low. I’m just looking to make a few extra thousand low-risk dollars this year. Now, the premium is $502. Now we’re talking!

But what if I change the strike price to $160?

Pop Quiz: If the strike price changes to $160 from $165, in which direction will the premium move?

You should have said it would increase. That’s because the stock is going to reach $160 before it reaches $160. More risk, more premium.

In this example, the premium is $867, with a strike price of $160 and an expiry date of June 28th.

However, as with any investing activity, we need to know our return to decide if it’s a good investment.

By the way, before we calculate the return on selling covered call options, I made a video years ago on the Airbnb IPO.

How To Calculate A Return On Selling Covered Call Options

 

The return on investment formula is the exact same as it is for Put options, but given the complexity of this topic, let’s run through the example.

Please do it first on your own and compare your result with mine.

We will Sell to Open five Covered Calls on ABNB with a strike price of $160 and an expiration date of June 28th for a premium of $867.

Remember: premium received / cash risked or collected on the stock sale.

In this case, we received $867 and would have collected $80,000 (5 options contract * 100 shares * $160 strike price). So $867 / $80,000 = 1.1%.

However, we earned this return in only seven weeks, and we want these return on investment numbers to be comparable, so we need to convert them to an annual return. What if we did this same trade every seven weeks this year? What would be our annual return?

We would multiply by 7.4 (52 weeks / 7 weeks) because we could do this trade 7.4 times per year. So, 1.1% * 7.4 times per year = 8.1% annual return.

And that’s not too shabby for a disappointing stock with limited risk of going bankrupt. Basically, I’m buying time, hoping that either the company management will improve and the stock price will rise, or the company will start to falter, and I’ll simply sell the stock at the given price if I think the future trajectory is an ever-lower stock price.

How Does Volatility Affect Options Trading?

 

Volatility represents how wild the upward and downward swings are of the stock in question.

You can imagine if a stock is more volatile, how this would affect options trading. It would make it more risky. Thus, higher premiums.

ABNB stock volatility is 10.46%. This is not a volatile stock.

TSLA is 57.13%. Here is the TSLA stock price chart over the past five years. Compare it to ABNB.

The S&P 500, representing less risky companies, has a volatility of 15%.

The volatility of a stock will change over time, especially during earnings week.

Four times per year, a public company will announce earnings. Your trading tool should clearly show which week is earnings week. You will want to avoid trading options this week as a new options trader.

But later on, you can leverage earnings week to maximize options profits.

For example, TSLA stock recently shot up from $165 to $185. It was due to some positive news, not earnings, but both work the same way. Earnings weeks are more predictable because we know when the big news will come out.

On a Monday, I Sold to Open five Put options on TSLA with a strike price of $175 and an expiration on that Friday. I collected a premium of $812.50, and my annual return was 48.8%. The options contract expired out-of-the-money, I kept the premium, and my options trading record remains at a 100% success rate.

options trading beginner guide selling to open puts on tesla tsla

The Argument Against Trading Options

The biggest argument from people unfamiliar with options trading is that you make such small amounts. $50, $100, $200 trades, typically with my strategy. AND you’re risking ten, twenty, or thirty thousand dollars.

It doesn’t seem to make sense.

Well, that is already accounted for. Above, we’ve already verified that the return on investment on any single traded is valid. That’s great, but one thing often overlooked by options traders (and Uber drivers and nearly everyone on the planet, it seems) is their hourly rate in any given activity. Below, I discuss that topic.

The one valid argument against trading options is that you can’t be a casual options trader. If you’re putting aside $50,000 as collateral to trade options, then you have to trade options consistently to make enough money on that collateral to make it worthwhile.

Let’s run through an example. Both options traders are using $50,000 in collateral. That means if you are selling Puts, you have the cash in your account to buy the stock if the option is exercised. In this case you can sell the quantity of Puts on stocks that would require less than $50,000.

Example 1: You trade a few trades monthly. Let’s say that grosses you $3,600 annually. This is an annual return of only 1.8% on that $50,000. Pathetic.

Exmple 2: You trade consistently every week for the whole year. Let’s say that grosses you $14,400. This is an annual return of 7.2% – just fine if you’re not a professional trader, as this strategy is without much risk (thus lower returns).

In example 1, what else could you do with that $50,000 collateral? For one, ou could put it in a riskless CD with a bank and earn double the return on your money.

That is the only valid argument against trading options.

Even Easier: Covered Call Options ETF

options etf covered calls xyld how to beginner easy stock trading

If you want some of the benefits of selling options without any of the management, enter a covered call ETF.

XYLD. That’s what you’ll want to type into your stock exchange platform like Charles Schwab.

Currently, its yield is over 10%. Another word for yield is dividend and it’s how much the stock pays out. In this case, XYLD pays out every month.

But, let’s run though a hypothetical example assuming you purchased 100 shares five years ago at about $50 per share.

Total cost: $5,000

Number of shares of XYLD: 100

Total dividend payout over 5 years at 10% yield? The 10% does change, but for simplicity of this example, let’s say that all five years were at 10%. In this case, you would have earned dividends in this time of $2,500 (10% of $5,000 is $500 annually multiplied by 5 years).

How much did the stock price change? It went down from $50 to $40 for a decrease of 20%. Your investment went from $5,000 to $4,000 ($40 * 100 shares).

You lost $1,000 on your capital, but you made $2,500 in dividends over this time period. That equals about 6%. Not too shabby.

Of course, dividends are taxed as short-term gains at your regular tax rate, while capital would be taxed at the long-term gains rate of 10 or 20%. This needs to be factored in, but in our scenario, you still did pretty good especially if you factor in the fact that you spend no time managing this investment.

Conclusion: Why I Trade Options

 

Firstly, how’d I do in explaining my easy options trading strategy? Tell me in the comments.

Why do I trade options? You can make 15% on conservative options trading. While this isn’t passive, it’s also not very active. The most active I’d be as an options trader is spending a few hours per week managing my trades.

You can make 25%+ trading options, but this requires more of your attention and requires you to know more advanced options trading strategies.

I like to think of things an hourly rate.

If I use a balance of $100,000 to make $15,000 per year while spending 156 hours (3 hours * 52 weeks), my hourly rate for this activity is $96.15. That’s good.

My hourly rate on The Belmonte Penthouse, a short-term rental Airbnb investment I have in Medellin, is $342.

You adjust the numbers based on your situation and come to your own conclusion as to whether or not options trading the easy way is a worthwhile investing activity for you. It was for multiple multi-millionaire, Roy.

By the way, not being passive investing means I have more control over it. If you’re a good investor, you seek control as it results in a higher return. For me, not being passive means I’m making a higher return.

Compare that to my passive investing blog post, where you can expect to make somewhere between 3-6% returns.

Speaking of my Airbnb investment, a more active investment, and a headache in a half. I’m constantly coordinating things to be fix, repaired, or replaced. I also have to deal with other humans and play politics in the HOA. These are severely unenjoyable activities for me, and I want to avoid them at all costs. Thus, if I make another real estate investment, my hourly rate on that investment must be $180+ per hour. That would mean the return needs to be 30%+. Luckily, my return there is 33%.

Happy options trading aspiring investors! I’d love to hear from you in the comments. I know you want to share some advice or expand upon some concepts I shared in this blog.

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