Everything You Need To Know About Options Trading

Cody here.

Since I launched the hedge fund five years ago, we’ve been using options a lot more than I had been in the years when I was only trading/investing my own capital in my personal account. Consequently, I’ve received a lot of questions about how options work, when we choose which options to use, and why.

I asked Bryce to write up an Everything You Need To Know About Trading Options booklet for our Trading With Cody subscribers and here it is.

So without further ado…

Everything You Need To Know About Options Trading

Bryce here. We wanted to put together a short primer discussing stock options: how they work, how we use them, and the risks involved. At the outset, we want to be clear that WE RARELY TRADE OPTIONS in our personal accounts. Options are inherently risky and we use them primarily in the hedge fund for hedging purposes. That said, we do share some of our hedge fund option trades with subscribers when we are more convicted in the setup. But that does not change the fact that options are very risky, short-term investment vehicles that are not appropriate for many, if not most investors. Even if you are right about your analysis of a stock, it takes an incredible amount of good timing to make money with options.

Remember that something like 80% of all options expire worthless.

We hope this article will be a useful starting point for subscribers with as little as zero experience trading stock options. There are many advanced option trading strategies out there but we do not use those strategies often in our trading and thus we will not discuss those here.

Part I: The Basics

There are two types of option contracts available for trading: puts and calls. A call option gives the owner of the option the right (but not the obligation) to buy 100 shares of a stock at a fixed price (known as the strike price) on a certain date (known as the expiration date). The value of a call option generally rises if the price of the underlying stock rises. A put option is the inverse of a call. The owner of a put option has the right (but not the obligation) to sell 100 shares of a stock at a fixed price on a certain date. Puts generally gain value if the price of the underlying stock falls.

The price you pay to purchase an option is known as its premium. There are essentially two parts to an option’s premium: intrinsic value and time value. Intrinsic value exists if the options are in the money. Call options have intrinsic value when the current stock price exceeds the strike price, and vice versa for puts. Time value exists because there is a possibility that the stock price will change over time. Even if an option is out of the money today, it still has value because it won’t expire for a certain amount of time, and it could be in the money eventually. With options, time is literally money, and the longer you go out on the expiration date, the more expensive the option will be.

It’s also important to be aware of what’s known as the Black-Scholes pricing model. This equation provides a theoretical “true value” of a stock option based on five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility. It’s not important to know exactly how Black-Scholes works, but it can be useful to check the quoted price of an option against the Black-Scholes model. If the quoted price is dramatically more expensive than the result of the Black-Scholes equation, then you might be overpaying for the option. Cody and I don’t use Black-Scholes per se, but it’s important to be aware of it. Most online trading platforms have built-in Black-Scholes calculators, but you can also use free versions online at sites like OmniCalculator.com.

a. Going Long

If you buy a call option, your maximum gain is infinite and your maximum loss is 100%. Let’s use an example to demonstrate. Right now, you can buy calls on Robinhood Markets (HOOD) stock with a strike price of $14 that expire on June 14, 2024 for a price of $1.27. At this moment, HOOD stock is trading at $12.12. This call option is what we refer to as “out of the money” because the strike price is greater than the current stock price. If HOOD stock is not above $14 at the close of trading on June 14, 2024 (15.51% higher than its current price), the call option will expire worthless. Even if doesn’t expire worthless, you need it to be at least $15.27/share ($14/share + $1.27 premium) on the expiration date in order to cover the cost of the premium you paid for the call option, which would be a 26% move up from the current quote.

If HOOD’s stock is not at or above $14 on the expiration date, you lose 100% of your money on the trade. If HOOD stock is at $15.27 on the expiration date, you will break even on the trade. And anything above $15.27/share is profit. There is no limit to how high a stock price can go. Let’s say something amazing happens and HOOD is at $50/share on June 14th, then your call option would be worth $36/share ($50 minus $14), yielding a 2,735% return on your investment (calculated as ( 36 / 1.27) – 1)). That’s compared to a 313% return if you had simply bought the common stock. Demonstrating the power of the leverage that is built into options.

b. Buying Puts

Put options work essentially the same way except that there is a limit to how low a stock price can go ($0), so the maximum profit is not infinite like it is with a call option. You can buy a Feb. 16, 2024 put on General Motors (GM) with a $35 strike price for $0.78. GM stock is currently trading at $36.70. Again, to break even on the trade, GM needs to fall to $34.22/share ($35/share – $0.78 premium) by February 16th. If GM were to go bankrupt and somehow the stock went to zero by the expiration date (unlikely), the $35 put option would be worth $35, yielding a return of 4,487% ((35 / 0.78) – 1) compared to a 100% return if you had simply shorted the common stock.

c. Shorting Calls

Another common strategy that we use from time to time is writing (short selling) call options. We use this most commonly as a hedging strategy to protect our long common stock positions. When you sell a call option, your profit is the premium you receive upfront and your maximum gain is 100%. Your maximum loss on the call is infinite.

One very important difference between buying a call and shorting a call is that the short seller is obligated to sell the underlying stock if the call option is in the money (if the stock price is > strike price). If you own enough stock to cover the short call option, then you are simply forced to sell the shares you own at a price that is lower than the market. But if you do not own all of those shares, then a short position will be opened in that stock in your account and you could be subject to margin calls if you do not have the required equity in your brokerage account.

The most common way we use call writing is known as a “covered call” strategy. In this scenario, we sell call options against our long common stock positions which essentially caps the gains on the stock at the strike price plus the premium received. This is a good strategy if you are not very bullish about the near-term prospects for your stock holdings but want to continue to own them for the long term. We mostly like to use it when our stocks go parabolic and the premiums on the call options go through the roof.

Let’s use Intel (INTC) as an example (although we are not actually shorting/writing calls on INTC right now). Intel currently trades at $48.28 and let’s say we own 100 shares of the common stock. We can use a covered call strategy to increase our returns given our outlook. Right now we can sell an at-the-money ($48) call option for June 14, 2023 and receive $5.30 in premium (times 100 shares). If INTC is flat or down for the next six months, the call option will expire worthless and we get to keep the $530 we received in premiums as 100% profit. Another way to think about this return is that the premium is equal to an 11% return in six months on the value of the common stock position ($530 in premiums divided by $4,828 common stock position). However, if INTC is up significantly over the next six months, our gains are capped once INTC reaches $53.3/share ($48 strike price + $5.3 premium). In this example we own 100 shares of Intel, and if the stock runs to $75 we will miss out on $2,170 in gains on the combined position. If INTC drops to $40, we will keep the $530 in premiums but have unrealized losses of $828 on the 100 shares of common. Once the call option expires, we can sell another call option against our 100 shares and use the same strategy again to earn more income.

Part II: Trading Strategies

With the basic mechanics of options behind us, let’s talk about how we actually use options in the hedge fund. To begin, one of the goals of the hedge fund is capital preservation in down markets, hence the name “hedge fund.” Accordingly, we tend to keep our net exposure much lower than we do in our personal accounts. In our personal accounts for example, we are usually close to 100% long and maybe if we are really cautious, we sell some stocks and raise 10-20% cash. In the hedge fund however, we fluctuate between -20% and +60% net long most of the time. When the markets get extreme, we might get close to -50% or even more than +100% net long. In order to manage exposure in this way, we have to use a lot more options than we would in our personal accounts.

There are also economies of scale when it comes to options. In a multi-million dollar hedge fund, we can effectively use options without having too much exposure to any one security. However, if you have a trading account with only a few thousand dollars, even one call or put option will give you way too much exposure to a single stock. For example, let’s say you have a Robinhood account with $1,500 in it. You could buy one Tesla (TSLA) $250 call for January 19th for $3.10/share or $310 total. Although this may not seem like a major position, that call represents the right to buy 100 shares of Tesla at $250, which gives it a notional value of $25,000 making it a 1,667% position in your portfolio. You never want to have that big of a position in any portfolio. Thus, options are simply impractical for many traders because they automatically create massively outsized positions that in turn create too much risk. Additionally, the bid-ask spread and commissions are much higher for options (especially on illiquid stocks) and can quickly eat up your gains in a small brokerage account.

a. Hedging With Puts

Our most basic use of options is buying puts on stocks that we think will go down. This is the primary source of our downside protection. We buy puts on the stocks of companies that we think are silly, scams, frauds, overhyped, and/or overvalued. Ideally, these hedges will pair up against our longs (think HUT or MSTR puts against our BITO long), but that is not always the case.

Buying Puts v. Shorting Stock. We buy puts because we are betting on stocks going down, but this can also be accomplished by shorting stock. When you short a stock, you borrow shares of the stock and then sell them in the open market, with the hope that you can buy the shares back at lower prices and return the shares to whom you borrowed them. When you short stock, your max gain is 100% and your max loss is infinite (the inverse of owning stock). Moreover, you normally have to pay interest on the shares you borrowed. Unlike with put options, there is no time limit on how long you can short a stock. But, if the stock moves against you substantially, you may have to put additional capital into your brokerage account to cover the losses (aka a margin call). For these reasons, in the hedge fund we frequently bet against stocks by buying puts instead of shorting the stock outright. Importantly, puts essentially act as a built-in stop loss for shorting because when the stock moves against you, you might quickly lose 100% of your money but the losses stop there. And because you are using leverage, you can get a lot of profit potential without risking too much capital. For example, let’s say you took $1000 and bought 10 Affirm (AFRM) $10 puts back when the stock was trading around $9 in March of 2023. When AFRM runs to $45, your puts would have expired worthless and you would have lost $1,000. On the other hand, if you had shorted 111 shares of AFRM back in March at $9, you would have received $999. When AFRM ran up to its recent price of $45 per share, those shares would be worth $4,995 for a loss of $3,996. Thus, puts are effective at preventing outsized losses when stocks make big moves to the upside.

When do we buy puts? It is probably fair to say that in the hedge fund we always have at least some puts on the books at any given time (again we rarely use options in our personal accounts). When markets — and especially small caps — start going parabolic (as they have at least five times in the last four years), we tend to get more aggressive in buying puts on the worst kinds of companies. This is the most aggressive hedging strategy because these stocks tend to be heavily shorted which means they can rally the hardest if things keep going up. As always, we buy options in tranches and never load up on what we think would be a full-sized position all at once. When we send out trade alerts that we are buying puts, you should expect that we will buy more in the days and weeks that follow if the stock keeps marching higher. At some point, we will be forced to stop fighting the stock (getting squeezed out as they say), and that usually happens if the stock moves at least 20 or 30% against us. Deciding whether to stop buying puts or buy more when a stock goes up is more of an art than a science.

Which puts do we buy? Premiums determine everything. The premiums charged for puts and calls vary widely depending on the specific stock and underlying market forces at play. Stocks with high volatility have higher premiums for both the calls and puts because everyone is expecting big moves in these stocks. The puts for heavily shorted stocks are also very expensive because there are lots of hedge funds like us that are betting on these horrible companies going to zero eventually. At-the-money options have the most time premium built in, thus, when the puts are really expensive, we will typically buy puts that are deeper in the money. The trade-off is that you have less built-in leverage. If the puts are really cheap and we are confident in our bear case, we might buy some slightly out-of-the-money puts which gives us more leverage if things go our way. In terms of expiration, we are usually buying puts one to eight weeks out, and we like to stagger the expirations so we don’t have too much riding on any one week’s price action.

When do we sell our puts? Shorts are not long-term holdings for us. All we are trying to do is protect the downside in our longs and thus if we get a decent-sized move down in any of our shorts — say at least 3% to 10% — we will usually trim a few puts. When bad stocks collapse, they can come back to earth very rapidly so we like to use a series of limit orders that ideally will get filled over time rather than blowing out of the entire position all at once.

b. Betting On The Come — Buying Calls

Buying call options is a risky strategy in that you need sizeable gains in the stock price and the right timing to make any money. The hedge fund has a long bias anyway most of the time, so we are not aggressively buying call options regularly. Most of the hedge fund’s capital is sitting in the common stock of our long-term holdings so we don’t need to buy a lot of call options to get long exposure. But there are definitely times when we can be opportunistic to add leverage to the long side using calls.

When do we buy calls? Typically, we buy calls in two situations (1) markets are extremely sold off; or (2) we have a high degree of confidence in some near-term upside catalyst.

The first situation is much rarer than the second. December 2022 and October 2023 were two perfect examples of this situation. In both instances, we started buying call options on stocks across our entire portfolio of long holdings after the broader markets were already down about 10%. When the markets get that ugly, the premiums on call options can get very attractive and we usually start placing limit orders that will get filled if our longs go down 3%, 4%, 5%, or more in a day. Sometimes this can happen for several days in a row and it can be sickening to watch the value of the calls you bought yesterday nearly evaporate the very next trading session. But if the timing works out and stocks rebound quickly enough, you can get 3, 4, 5, or 10 baggers in a few weeks or less.

This is basically the “buy the dip” strategy on steroids. It’s a great way to take advantage of oversold scenarios in bull markets, but it can be extremely expensive or even career-ending if you get too aggressive in front of a new bear market. For example, if you loaded up on calls in January 2022 after the market fell 10% from its all-time highs that previous November, you would have been wiped out when the markets fell another 20%-30% over the next twelve months. Again, timing is everything with options.

The second scenario is stock-specific. In this situation, we are wanting to add long exposure because we think there is a near-term catalyst that the market is not pricing in. This sometimes happens with earnings reports. Sometimes we might think we have an edge on an upcoming earnings report after we’ve completed our research and in-depth analysis about one of our stocks. Or maybe one of our companies is about to announce a new product/service that we think will be a game changer. Or maybe production numbers for a company like Tesla (TSLA) are coming out at the end of the quarter and we think they are going to beat estimates. If the calls are really cheap, we like to sneak in and pick up a few of them before events like this. This can be a little gamble-ey so we don’t want to ever get too aggressive with this type of call buying. A lot of other market participants can also see these kinds of catalysts and usually the calls are priced accordingly. We really like to see cheap premiums before we start bidding on calls in this scenario.

Which calls do we buy? We are usually buying calls on stocks we already own so there is no point in buying deep in-the-money options. We are looking to add leverage to the upside and the best way to do that is with slightly out-of-the-money options. We usually are looking at options with strike prices around 3%-5% or so above the current stock price. That usually means that the stock will need to pop a good 7%-10% or so for these call options to pay. If we are buying calls because of a near-term catalyst like an earnings report, we might buy calls with expirations within a week or two after the date of the expected catalyst. If we are in scenario one where the markets are selling off across the board, we like to buy longer-dated options — maybe 2-3 months out — that gives the market time to turn around.

When do we sell? If we are betting on a near-term catalyst, we are usually looking to sell if we get the move we were looking for. It is sort of a binary outcome with those types of trades. On the other hand, if we are buying calls across the board when the market gets crushed, we are much slower to sell those positions since we are betting on a broader rally. When the market starts to rebound from oversold conditions, individual stocks are not usually spiking 10% or 20% in a day like they might with a good earnings report. Also, we may take delivery of the common stock at expiration if we have big gains in the calls and are looking to build up the position.

Part III: Conclusion

Options trading is risky and not appropriate for most individual investors. With this primer in hand, we hope you can make more educated options trades if and when you feel it is appropriate for your individual account. Here are a few summary points to remember:

• Options are risky and should be used sparingly.
• Timing is everything.
• Premiums vary widely between stocks and in large part the premiums determine the best option strategy to go with.
• Out-of-the-money puts and calls lose money 80% of the time.
• A covered call strategy can be a relatively low-risk way to increase returns on stocks that you are not very bullish on in the near term.
• Enter and exit positions using tranches instead of going all-in or all-out all at once.

Happy trading! And again we would love to hear more questions this week about options trading.

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