Make Your First Stock Options Trade | Options De-Mystified

In this video, I’m going to cover what you need to know to make your first – hopefully profitable- stock option trade.

I asked on Instragram what questions you had about trading and the overwhelming response had to do with stock options, so I figured I’d break down the process of finding a stock to trade, deciding on calls or puts, picking an expiration date, picking a strike price, and selling it for profit.

If you don’t know anything about stock options, I made a video covering the basics linked here. Before we get too much farther into it let’s cover a few things:

First, options are risky. When you buy an options contract, you can end up losing your entire investment because the contract can end up worthless. More on that later - but just know that options are a riskier way to trade or invest.

Second, you need a brokerage that will allow you to trade options. I recently made a video ranking the five brokerages I have accounts with, which you can find here. You usually need to apply for options permissions with your brokerage, since there is a good deal of risk involved.

Third, options are complex. That’s probably why my broker sent me this beefy booklet about options when I signed up. There are complexities that you should be aware of like the greeks, intrinsic and extrinsic value, different spread strategies, IV crush, and so on and so forth. This video is for after you’ve studied and understand these concepts and now you want to see the process of actually making the trade.

Basics

Now hopefully you already know the basics and this will just be a refresher for you, but let’s do a quick overview.

When buying options contracts, you have two choices: calls and puts. Buying a call is a bullish position, meaning you think the stock price of the underlying asset will go up. So if you think Tesla’s stock is going to go higher, you’d buy a call on Tesla.

Buying a put is a bearish position, meaning you think the stock price of the underlying asset will go down. So if you think Ford’s stock will go down, you could buy a put on Ford.

Next, we have the strike price. Since a call option gives you the right to buy 100 shares of Tesla at the strike price, the strike price plays a major role in the value of the contract. If Tesla is currently trading at $671, you wouldn’t be interested in buying 100 shares of Tesla for anything above it’s current price… because you can just buy it at market value for cheaper. So a call contract with the strike price of $600 would be a lot more interesting. When a strike price on a call contract is below it’s current share price, it’s considered “in the money”. When it’s above the current share price, it’s considered out of the money. And the opposite is true for a put contract. When the strike price of a put contract is below the current share price, it’s considered in the money. When it’s above the current share price, it’s out of the money.

Next, we have the expiration date. Since an option contract gives you the right to buy or sell 100 shares of the underlying before it expires, the expiration date is really important. The more time you have on a contract makes it more valuable… and that makes sense from a logical point of view. If you have a call contract on Tesla with a strike price of $800 but it expires in one week, well the odds of it increasing $129 in one week is very slim, so that’s not as valuable as a contract that won’t expire for 18 months. It’s far more likely that the stock price would be $800 or higher in January of 2023. But because of that reason, contracts with more time on them are more expensive to buy.

Finally, let’s talk about the spread. The spread is the difference between the bid and the ask for a contract. If you want to buy a contract, you usually end up paying close to the ask price or maybe somewhere in the middle. Ideally, you don’t want a spread that’s more than 10% of the cost of the contract. The slimmer, the better.

Basically, if you bought a Tesla call option with a strike price of $675, you might pay $3,155 for this contract. If you wanted to immediately sell it, you’d have to sell it for $3,080. That means you’d lose $75 because that is the difference between the bid and the ask. Remember, you multiply these amounts by 100. That amount you lose from buying and selling is referred to as slippage.

On SPY - the S&P 500 ETF, the spread is extremely tight. Here, it’s a 3 cent spread… which equates to $3, which is good.

So those are the absolute basics. Let’s move on.

Making the Trade

When it comes to trading stock options, you need to first know how long you want to be in the trade for. You can daytrade stock options, in which case you’re probably trading contracts that expire that same week – called weeklies. Or maybe you’re going to hold the position at least overnight and maybe for a week or two. In that case, you’d be better off buying something a month or two away from expiration. Or maybe you want to hold the position for several months, in which case you want something closer to a year or more until it expires.

Lately, I’ve been daytrading stock options… generally holding a position for less than 30 minutes. But for this video, let’s look for a swing trade. This means when I pull up a chart, I’m looking at longer time frames, usually starting with the daily. That means each candlestick represents one day of trading. Now I made an entire video about identifying support and resistance levels, so I’d recommend watching that if you haven’t already since knowing these levels will help us make a better trade.

Let’s take a look at JP Morgan Chase. Not the most exciting stock, but we can see it’s been in this nice upward trending channel over the past year. We can see we bounced off of horizontal support and it’s near the bottom of the channel. If we think the financial sector will perform well over the next few days and weeks and we think JP Morgan in particular will continue on this uptrend, we may want to buy a call option on it, so let’s take a look.

By the way, the platform I’m using is ThinkorSwim, but most brokerages should have an option chain that looks something like this. Today is June 25th, so let’s take a look at 2 months from now for August 20th expirations. The share price is currently $154.05, so we could grab these $155 calls. The spread is only 15 cents which is great… and these will cost $470 apiece. The delta is .48, which means if JP Morgan’s share price increases one dollar, our contract will increase in value by $48. You can also think of it as the equivalent to owning 48 shares.

This contract has a theta value of -.04, which means we will lose $4 in value the next trading day if everything else remains the same. So we need JPM to increase in price and not just trade around sideways, or it will eat away at the value of our contract. The closer we get to our contract’s expiration date, the more time decay will eat away at the value. And in case you didn’t know, these greek values associated with the options contract will fluctuate over time, and that, in turn, will affect the price. So the theta value is -.04 now, but we can see that on the same contract expiring next Friday, the theta value is -.12, meaning time decay is really starting to negatively impact the value of the contract. We can expect the same thing to happen to the August 20th contract the closer we get to August 20th.

So let’s go back in time a few days to June 22nd and go through a pretend trade. If we were watching JPM, we saw that it hit horizontal support and the bottom of the channel. Then, on the 21st it had a nice green day, confirming that the support held.

The share price is around $150 so let’s look at the option chain. The $155 call option for August was $345, so if we bought two, it would have cost us $690. Even though the breakeven price listed when we place our order is $158.45, we don’t really need to worry about that since we don’t plan on holding this contract until expiration.

And that’s something I see a lot of people get tripped up about. They’ll see the breakeven price displayed when they place their order and think the share price has to be over $159.70 for their options contracts to be worth anything, but luckily that’s not the case.

Your options contract’s value will increase and decrease throughout the day as the stock price moves. You can sell the contract whenever you’d like – you don’t have to wait until expiration and in most cases, you don’t want to wait until expiration.

Now as soon as your order fills on the contract, you’ll likely see that you’re in the red a certain amount of money. Remember the bid-ask spread? That’s the spread taking effect, and it’s not a big deal here. It’d show us in the red $10 on the trade, but as soon as the share price starts to move up, we will see our contract increase in value.

So now jumping back to present-day, just three days into our trade the share price is now $154 and the options contract is $470 – which if we sold at the bid price of $455 per contract, we would make $220.

Not bad! If you’re happy with that profit and want to exit the trade, you can sell the contract to close it out and lock in the profit.

To me, the chart looks good and we have plenty of time left on this contract, so I would continue to hold it here a bit longer to see what happens. If the stock just chops around in the mid-50s like it did back in February and March, I’d probably cut the trade loose. The other thing to keep in mind is JPM has earnings on July 13th before market open. We’ve seen some sell-offs after earnings this year, so it might be a good idea to close out this trade before then.

So let’s recap that pretend trade really quickly.

We found a stock that tested support and bounced off of it. We were bullish on the company and saw it was also in a long-term upward trending channel and it was near the bottom of this channel. Since JPM isn’t super volatile, we wanted to give the stock time to move upward, so we looked at the option chain for August, about two months away. We went one strike price out of the money, which had a 10 cent spread. We paid $690 for two contracts, which is also the most we would ever lose on this trade if JPM went bankrupt tomorrow.

Just three days later and we are up 30% on the trade and can sell here or continue holding to see if the stock price continues its upward trend.

But let’s say this trade went against us. At what point do we cut the trade for a loss?

Well, I would look to cut it below our support level. If the price breaks support, it’s likely to continue downward and I no longer want to be in the trade. With options, I don’t recommend setting a hard stop-loss. Instead, set a mental stop loss. So what I would do is add an alert to my chart so if price drops below our support, I can take a look and manually exit my position. This is because the way options pricing works between the spread and the greeks impacting price, you can lose more money with an automated stop-loss. So instead, set an alert, confirm support is broken, and then exit.

Implied Volatility

I want to cover one more topic that’s essential for you to know about, and that’s implied volatility. Let’s say you’ve watched AMC go from a few bucks all the way up to $72, and now, you’re certain it will come back down to earth soon. Let’s say you think by August 20th, it will definitely be under $50, so maybe you want to buy a put on AMC with a $50 strike price. The first thing you’ll notice is the options premium is jacked. That put costs $1,450. One of the reasons why is because the implied volatility is incredibly high at over 200%. As expectations for a stock change, so do the pricing of option premiums. The market makers realize that AMC could move a lot in either direction, so they need to protect themselves by charging a higher premium. Here in ThinkorSwim, on the right, we can see market makers are expecting a 44 and a half point move in either direction by August 20th, so they’re going to make sure they get paid to take on that risk. The stock’s volatility, plus demand for the contracts themselves will cause implied volatility to increase.

In this instance, you really need the stock to drop a lot to see a decent return on your money. And if the stock does drop and implied volatility drops along with it, you may not see any return at all. Let’s take a look.

We have dates on the top going all the way to our expiration of August 20th. If we bought this put contract today for $1,438, and Monday it drops to $49, we would be up $141. But what if price drops, but implied volatility drops as well? If implied volatility drops to 185% – which is still high – we are in the red $17 if AMC is at $49. We need it to drop even lower now.

If Implied volatility dropped all the way down to 99%, you can see we only start making money when AMC is at $36 and it’s still only $130 – less than 10% return on our investment. And every day that passes and AMC doesn’t drop or implied volatility lowers, we are losing money on this trade.

This is what people are talking about when they mention IV crush. It happens all the time after a company releases earnings – people with call contracts wonder why they still lost money even though the price went up. Implied volatility drops after earnings and affects the pricing of options contracts. So be careful and try not to buy contracts with high volatility until you have more experience.

Final Thoughts

Options can be a really great way to leverage your money into higher returns, but of course, they come with greater risk. I hope this video helped illustrate the ins and outs of making a trade and as always, if you have any questions about anything I covered or didn’t cover related to options, let me know in the comments and I will do my best to help you out.

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