Option Trading: My Caramel Macchiato to your Black Coffee

Christopher Irvin |

Starbucks.jpg

Starbucks Corporation (SBUX) shared its earnings report with the world in January 2015 and the numbers show that the company is still steaming hot. When you think about it, it's amazing that Starbucks is still “a thing.” There were a lot of “old timey” coffee drinkers that scoffed at a company that said they would build a business around the concept of making coffee “cool.” These naysayers also did not think it was possible to sell a thirty-five cent “Cup-O-Joe” for upwards of $5.00 per cup. Regardless of what you might have thought about Starbucks 30 years ago, you can’t argue with the fact that five stock splits later, the company’s shares are closing in on the $90.00 mark. The marketing pros at Starbucks were able to create an entirely new demographic of coffee drinkers. I have to admit, I was part of that new demographic. I hated coffee; that is, until I was introduced to a Caramel Macchiato. After my first CM (hip lingo for my new favorite drink!), I would stay up late at night trying to memorize that a “grande” was not a large, and “tall” really means small, so I did not sound like a rookie to the coolest people on the planet - the baristas. The baristas have the power to make coffee taste really good by doing really creative things to really bitter stuff. 

I Like My Coffee Like I Like My Equity Options

When I was younger, I used to think of stock trading the same way that I thought of black coffee: kind of bitter and boring.  I knew that people traded stocks, but I really wasn't interested in joining them. Even when commissions became really cheap, I still was not interested. It still seemed like a game for stuffy, rich people. I did not consider myself to be either one. So what was the Caramel Macchiato that brought me into the trading world? Equity options.

When I was exposed to equity options trading, I found out that I could use them to tie up less money in trades and generate a rate of return that stock traders could only dream about. That combination piqued my interest. As I investigated options further, there were four reasons that I thought options might be my best entry into the trading world:

1.    Leverage

When you are trading equity options, you are using a derivative of a stock (call or put) to take advantage of the ups and downs of the stock’s price. Those derivatives can be purchased at a fraction of the price of the stock. For instance, at the time that I am writing this article, SBUX is trading for $87.90. But, if I wanted to trade the call option on SBUX, it would have cost me anywhere from $0.59 to $4.60 per share, depending on which option I wanted to trade. And what kind of returns might I have made? If I went with the $4.60 option, I could have made roughly 70% off the stock’s move. Are you starting to see the appeal of options trading? In this example, I would have put up just over five percent of the stock’s price to get into the trade and had the potential to make 70% of the profit of the stock trade. 

2.    Reduced Risk

If you are not familiar with options, you may be somewhat confused by this benefit of trading options. Why? Because options have a bad rap when it comes to risk. There are a couple of reasons for this. The first is that all options have an expiration date associated with them. This means that on a certain date, the option will cease to exist.  If you purchase an option, forget about it, and let it expire, you will lose everything you put into the trade. This is unlike a stock trade as stocks do not expire. The second reason that options are misunderstood in the risk department is because the leverage component of the option can swing both ways. The leverage that allows option traders to make better-than-average returns can also increase the risk to the trade if you do not understand proper money management. Neither of these seem like great reasons to want to start trading options, but like I said earlier, there is a way to look at options that will allow you to reduce your risk and not increase it. 

Let’s say that I have a $10,000 trading account and I think SBUX is heading up. If I buy 100 shares of the $87.90 stock, it will cost me $8,790.00 of my $10,000.00 account to enter the trade. If I place a five percent stop-loss on the trade, the risk to the position is $439.50 (five percent of $8,790.00). The risk to my $10,000.00 trading account is 4.4 percent. If I instead decide to trade to take advantage of the SBUX move with the $4.60 call option as mentioned above, that trade would cost $460.00. This is the first way in which trading options can reduce your risk in the trade. Obviously if you are using less money, there is less risk. 

The second reason that the option trade would offer less risk is based on the way options move. I stated above that my $4.60 option would give me the ability to make roughly 70% of the profit in the stock trade. The same thing applies to the losing side. If the stock moved against me by five percent, my option would absorb 70% of that loss. So the actual loss in the option trade would be $307.65. Right about now is the time when most people say, “but Chris, if the trade costs $460.00 to get into, and the risk in the trade is $307.65, you are talking about losing 66% of the position as your worst case scenario, aren’t you?” And they would be correct. But, when you trade options, you should not focus on the risk to the individual trade; instead you should focus on the risk to your total trading account. The risk with the stock trade is 4.4% of the $10,000.00 account. The risk with the options trade in this example is only three percent. The mistake that most uneducated option traders make is that they over-leverage the position. If you understand how to manage risk, you will understand that option trading could be less risky than stock trading.

3.    Creativity

Option traders have the ability to create strategies that stock traders have no way of creating. For instance, earnings season can be a very scary time for stock traders because of the volatility that can accompany those announcements. The following are the four possible outcomes for a stock’s price after its earnings are released:

  1. The news is good and the stock goes up.
  2. The news is bad and the stock goes up.
  3. The news is good and the stock goes down.
  4. The news is bad and the stock goes down.

Any one of these scenarios is possible, so take your guess. Alas, this is where the creativity aspect of option trading becomes evident. With options, you could create a strategy which allows you to profit if the stock moves up or down. With this strategy, you don’t care which direction the stock actually goes. This can be very appealing to a trader.

4.    Protection

The final benefit of trading options is that you could use them to protect your stock positions. In most of the conversation above, I have been speaking about SBUX moving up. In that situation, we could purchase a call option to take advantage of the move. If the stock were to move down instead, we would purchase the other type of option, known as a put option. A put option has the ability to protect your investments from loss. 

With all of that said, if you have never given options trading a try, you might consider educating yourself and starting to work on some venti-sized profits.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
SBUX Starbucks Corporation 58.60 -0.16 -0.27 6,156,154

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