I previously talked about how you can start taking a step forward to achieving economic freedom by investing passively and long term. However, today I want to show you a different side of the story… I want to show you how you can go from owning a house to probably owning just a mc chicken within months or even days, or how you can make $6000 out of a 1600 dollar investment overnight…
Today I will introduce the concept of options trading. If you don’t know, options are insurances (contracts between the owner of 100 stocks and the buyer of 100 stocks). There are two types of options: Calls and Puts. The calls give the buyer the option to buy a stock at a certain price and the puts give the seller the option to sell the stock at a certain price. So for the purpose of this blog, a call option will gain value as the stock price goes up and the put option will gain value as the stock price goes down.
Now, why trade options instead of stocks? The answer is simple: options provide you more leverage. Let’s say if the stock goes up one dollar, your overall portfolio will gain one dollar. But if you own a call option, if the stock goes up one dollar you can gain 40$ per dollar move or even 90$, depending on the delta of the option.
You are probably asking, why doesn’t everyone trade options instead of stocks and the answer is that options can expire worthless, making you 1500 investment turn into 0 in one week or less. 
This is a call option for Tesla worth over 16 grand, the stock is currently trading at $427.28. In this case, this contract expires this Friday, and if the stock is under 427.50 dollars your $16.68 x 100 (because it involves 100 shares) will go to zero, in other words, you will lose you $1668 dollars in just 3 days. That is the risk involved in options trading. But if you look at the delta, the contract will gain almost $52 dollars per $ up move on the actual stock, so that is certainly good. All these weird names are called the Greeks of options. Delta determines how much your contract will win or lose value per dollar move, gamma will determine how your delta changes as the stock keeps going up; vega determines how much money your contract will gain or lose if the implied volatility increases or decreases, and I don’t know what rho means honestly. However, I want to focus on theta, most commonly known as time decay, the biggest fear of option buyers.
The bad thing about options is that they have an expiration date, unlike stocks. For this high risk, you will receive a high reward or nothing at all. This is the graph of an options contract over time. As you can notice, your contract is losing value from the moment you buy it. However, the time decay starts eating your contract aggressively the closer it gets to the expiration date, as seen by the strong curve downward that reaches towards day 0. In our previous Tesla contract, because we are just 3 days from the expiration date, you will lose 420 dollars per day, that is absolutely insane.
If you see this contract that expires in 2021, you will notice that the time decay is much lower at about 35 dollars per day. Although it seems like a bad idea, I want to emphasize that the time decay is most notable when the stock is trading sideways, aka the price at the end of the day is the same as the price at market open, so if the stock moves up, the delta will outweigh your time decay by far. For other stocks, time decay might not be so high, sometimes it can be $1 or $10 and the option prices are cheaper. But because this is Tesla, one of the most volatile stocks right now, the sellers price in that volatility in the price of the contract because they know that the chances of you making money from it are absolutely high. Tesla, known for making $50 moves in one day, can make you a return of $2500 in just one trading day, that is the real reason why buying one of these contracts is so expensive. This is one of the ways you can make precious returns or make your investment worthless. Next week I will be showing you what I mean by making your investment worthless.
Wow, this was a lot of economy vocab, but you did a very good job of explaining it to someone like me who doesn’t have much of a background in economics. I honestly didn’t know options trading was an option, but after you explained it seems like a good choice for anyone who understands the stock market and option trading works. I really appreciated when you said you just didn’t know what rho meant, but it doesn’t really matter because it kinda brought the blog back to a very relatable place for any readers who don’t have an economics background.
Wow, I never even knew that this aspect of the economy existed. It’s incredible that people are so willing to put their money into options. I don’t think I’d ever be willing to take that type of risk unless I did a lot of research about options or had someone else do it for me. I’m curious about one thing, are there indicators people use to predict the value of options? Are these indicators reliable? If so, it seems like people would be able to get rich easily with these.
Indicators have their flaws and can sometimes give false signals. For that reason, it is better to use two indicators at a time and be sure that you are using a bigger candlestick (timeframe) in your chart to view the bigger picture. Moreover, it is important to picture that market news heavily influence the stocks to move. Even a tweet from Donald Trump will be able to make the market go down even though the indicator says it might be oversold.
Topics about finances or money rarely pique my interest, but your blog post made economics sound appealing in an educational way. Like the other comment, I was also never aware of options, calls, and puts before. The amount of money that can be generated from an option is crazy, but so is the amount of money that can be lost too. Out of curiosity, did the pandemic have an impact on options? I have a feeling that it did, but that’s about all I can infer. Great job, Diego, and I’m excited to read your next post!
Hello Alexandria, I’m glad that you liked it. After the pandemic, options were inflated as the daily high percentage moves were present. As they know you can profit from that, the options contracts were almost 200% or 300% more expensive. Crazy right???
I’ve been trading options a little bit over the past few months, and I think you nailed the explanation of how it works. It’s very different from trading regular stocks. As you mentioned when the stock trades sideways you still lose money. If you make a good call/put, you make money almost exponentially as it goes toward your prediction. However, the opposite is true if you’re wrong. Have you had any personal experience trading?
It is nice to hear that! I started my brokerage account back in January and I had a good experience trading options during that stable market; however, after the market crash, I had to stop buying options as nailing the move was almost impossible.