People usually look into options trading because they think it’s a means of getting rich quickly. Yes, there are instances where some have definitely made an enormous amount of money very quickly but the truth of the matter is very few have done that and most have lost money.
This is more of my opinion on how someone should start with options or better yet now that I know better if I could have a redo then this is how I would start with options. This is not a get rich quick method at all. This would probably fetch you between 5% – 20% a year if everything goes well.
So with my redo, I would start with something simple and straightforward. Selling a put would be the easiest to start and it’s also something that could be understood because it’s the closest thing to buying stock directly.
Before getting into the details too much, there are definitely some requirements that needs to be taken care of
- Understand what options are
- Brokerage account
- Small list of companies that you’re willing to buy
- Understanding your risks with selling a put
The order I have listed above is not perfect, it’s what made sense to me. The important matter is that you understand what all of it is and know the risks you are taking on.
Understanding what options are
Since this is a write-up about options and how to start with options, it’s quite important that you know what options are and I have a write-up on this that I did a while ago that you can find here. If you’re short on time the part that you want to look out for is selling put options.
You already know this, you need to have some money if you want to start investing. Better question is how much money? Starting off with options $5,000 seems like a decent number for a beginner. It goes without saying the more you have, the better. More money gives you a lot more flexibility.
If you are already investing then this is not really a concern. Most likely, the platform that you’re on already has options capability.
If you are looking for one, Thinkorswim by TD Ameritrade seems to be the most popular platform from what I’ve read. I have not used them so I can’t be sure.
I started investing in 2016 on Robinhood and i think my first options trade was on Robinhood in June 2018 and I have continued using them.
If you’re signing up for a new account, you should look for commission costs and check if they have any promotion so you can get some freebies while you’re at it.
And a word of caution some of the brokerages have a tendency of saying commissions are $0 per trade but they usually have something written in smaller font that says it’s $0.65 per contract so it’s not exactly zero dollars per trade for options.
Small list of companies that you’re willing to buy
You’ll be creating a watchlist of companies that you’re interested in buying. The rule of thumb that I would use if you’re starting with $5,000 would be to find companies that are $25 per share and below. You can scale this up based on how much you’re starting off with. If you have $10,000 then $50 per share.
I’ve used finviz screener to come up with my watchlist because they have a filter for price that gives you under $10, under $20 etc. It doesn’t have an under $25 in the dropdown menu but you can fiddle around and create a watchlist with a few companies to your liking.
How did I come up with $25 per share as the threshold for a $5,000 account? it’s what I’m comfortable with. More on this below.
Technically the smaller the better so the $25 is just a guideline of what your upper limit should be.
Understanding your risks
If you read the post on what are options? and particularly the selling put options portion then you know if you’re using the $25 upper limit that I suggested earlier then that means that every time you sell a put, you’re allocating close to $2,500 as collateral (because each options contract is 100 shares).
This is also the reason why I said if your starting amount is $5,000 you want your stocks to have an upper limit of $25 because with each trade you’re probably risking half your money.
Now if you’ve done all these steps – good. you can start and this is what you’re trying to do.
You are going to take on the role of an insurance company. This is the best comparison that I could come up with.
Using car insurance as an example – you pay your premiums and the car insurance company provides you with coverage if you get into a fender bender.
By selling a put, you are the car insurance company. You will get the premium the moment you sell the put option and you will have to cover the costs if the buyer gets into a fender bender. Fender bender in this case would be the stock you sold the put on is below the price you picked.
The steps are as follows.
Pick the Stock
Most of the hard work for picking the stock has been done already with the creation of the watchlist. From the watchlist, pick the stock that’s having the worst day.
Pick an expiration
I typically like to pick an expiration date that is 30-60 days out into the future preferably the third Friday of the month. Third Friday is the monthly expiration, those contracts are the ones that are most sought after and the ones that people are usually looking to buy or sell. If you pick an expiration date less than 30 days, most likely you won’t be able to sell the put option for a price that is worth the risk you are taking on. This could vary a lot depending on the stock.
Pick the strike price you want to sell
Time to put on the bargain hunting hat and decide what discount you would like for the stock. A 10%-15% discount seems nice to me. so if it’s a $25 stock you want to look for a strike that is $22.5 or a bit lower. You can change this to your risk profile. The closer you are to the current stock price, the more risk you’re taking on and you get paid accordingly.
This is the car insurance portion where you want to get the premium or monthly payment or whatever you want to call it. I look for about 1% – 2% premium for the money that I have to set aside as collateral. If I’m using the $22.5 strike, then I’m committing $2,250 towards this investment. The premium I would like to get for this risk is about $45.
Premium is just the amount I get for selling the put option. 1% – 2% is just a number that I look for. Depending on how much risk you’re willing to take you can play around with this number. Stocks that’s considered risky will have more premium than the less risky ones.
So let me put this all together with the real stock to see what it looks like.
Step 1. Pick a stock – I’m going to pick a Rocket Mortgage RKT for the purposes of this illustration.
Step 2. Pick an expiration – I am looking for the next third Friday which is February 19th, 2021. This fits the guideline of at least 30 days into the future.
Step 3. Pick strike price – Stock is trading around $20 a share right now. I want the 10%-15% discount, I am going to play it safe and select the $17 strike put for my put options which is about a 15% discount.
Step 4. Collect Premium – $17 strike put is selling for around $55 which is a bit above 3%. Much higher than the 1% – 2% that I am usually looking for, so I am open to selling this put.
The mindset that I’m going to have here is that Rocket Mortgage is trading about $20 per share right now and I’m interested in buying the stock just not at the current price. However I’m willing to buy 100 shares of it at $17 by Feb 19th 2020. And getting $55 while waiting is not bad at all.
The best thing that can happen is Rocket Mortgage RKT stock price doesn’t go anywhere close to $17 and stays above the $17 per share price from now till February 19th 2021. If that’s to happen then I get to keep the $55 that I got initially and I move on.
The worst thing that can happen is Rocket Mortgage RKT stock price is below $17 by Feb 19th and it gets progressively worse the further away it is from the $17 strike price. For whatever reason, let’s say it’s trading at $10 by Feb 19th then I am forced to buy rocket mortgage at $17 a share but now since the stock is trading at $10 it’s only worth $1,000 for the 100 shares which is going to look like a loss of $700 but I guess I can feel okay about it because at least I have the shares now. I will probably have to hold on to them until the price recovers. This is also the reason why you want to only sell puts on stocks that you are willing to own. Do this enough number of times over and over and this is bound to happen at some point.
Let’s imagine that you are able to do this over and over for a year and are never in a position where you are forced to buy the shares, then this will make $55 about six to seven times a year which amounts to $330 on the $1700 you set aside as collateral. That’s about a shade under 20% return in a year which is really great.
One question that’s left over from all of this would be why should you have $5000 in your account if you are only planning to use only $2500 on each trade. That’s just leftover money to use whenever a great opportunity comes along. You never know when a great opportunity will come along and whenever it does you want to have the funds to do something about it. This cash reserve is also called dry powder.
For folks starting with options, this is going to be a bit cumbersome and it will take some time to get used to these steps. After a few iterations it will come more naturally.
This step by step cheat sheet of sorts would come in handy for people who are looking to buy specific stocks.
A few things to remember are pick companies you want to own, define the risk you are comfortable with and only sell puts for prices that you think are worth the risk you are taking.
Once you sell and you want to sound like a know-it-all then here two things you could say. I am going to use the Rocket Mortgage RKT example again.
- You could say you are short the $17 strike put – It means you sold the $17 strike put.
- You could say you are long RKT – it means you want RKT to go up in price.