What is options trading?

Football is back. Week 3 is complete and the excitement of the first two weeks has shifted to pure joy for the season. Saturday and Sunday routines are as they should be. If you knew me four years ago, watching football is the last thing you’d expect me to do on the weekend. Jules, a die-hard Georgia fan, converted me into a full-blown football fan… oh the things I do for her…

To start this letter, I need to tell a short story about my first exposure to options trading.

In late 2020 or 2021, my good friend Jack and I drove to Sonic as we avoided doing work. While we sat in the parking lot waiting for our loaded tater-tots to arrive, Jack was making his first options trade on TD Ameritrade (now a part of Schwab). I was googling “what is options trading” reading about the difference between puts and calls, longs and shorts, and strike prices and expiration dates. He was talking out loud while placing his first trade. 

I can’t remember what the trade was or if he made any money, but I remember the tots, the rising anxiety of work not getting done, and the experience of learning something new. The real option we bought that day was the option to be friends. 

““I would never say this to his face, but Jack is a wonderful person and a gifted trader.” - Michael Scott” - Wilson Meyer

So what did I learn that day?

An options contract gives you the option to buy or sell something at an agreed upon price by an agreed upon date.

Without using the word in the definition:

An options contract is buying the right (but not the obligation) to buy or sell something at an agreed upon price by an agreed upon date.

For example, you could buy the option to purchase a Yankee Candle next week for $20. You are not buying the Yankee Candle now, but you are buying the right to buy it next week for $20. 

Why would you do this? If you think the Yankee Candle will cost more than $20 next week due to a wax shortage, you buy the option now. Then, in a week, the market price might be $30 but you secured the option to buy it for $20. You buy it. 

Most options traders would say you should immediately sell it for $30 and make $10. That is the point of options trading after all… but instead, you keep it on your coffee table and use it as a conversation starter about options trading and Yankee Candles. Win - Win - Win

Okay analogy complete. 

There are two main types: call and put options.

Call Options:

• You have the right to BUY an asset from the writer at a specified price by the expiration date.

Put Options:

• You have the right to SELL an asset to the writer at a specified price by the expiration date.

How do you remember which is which?

If you want to BUY something, CALL them and let them know.

If you want to SELL something, PUT them down gently.

There are a few other terms used in option contracts:

• The Writer - the entity/person selling the contract who will be required to buy/sell the asset if the option is exercised

• Expiration Date - the date at which the contract will expire and you lose the option to buy or sell the asset

• Strike Price - the agreed upon price to buy or sell the asset 

• Premium - the cost paid to the writer today by the buyer to own the option contract usually expressed as a price per share

Call Example:

You love Google and think the value is going to rise significantly in the short term. Hypothetically, their stock is $150. You think it’ll go up to $160 easily. You buy a call option contract for 100 shares.

• Expiration date: 1 Month from Today

• Strike Price: $160

• Premium: $35 ($0.35 per share x 100)

Boom! The genius you are was correct. A month later, Google is at $165. You exercise your contract which means you buy 100 shares of Google from the option writer at $160. You immediately sell the shares for $165 for a $5 profit per share. 

Subtract the $35 premium and you made $465 profit. Your ROI was 1,329%.

If you were wrong, and the stock didn’t rise to the strike price, let the contract expire. You lost the $35 premium.

Without option contracts, you would have needed $15,000 cash to buy 100 shares of Google at $150. Then, when the price increased to $165, you would have made $1,500 but had an ROI of 10%. 

Put Example: 

If you think (know) that Boeing has nowhere to go but down (pun intended), you could buy put options. Hypothetically, their stock is $150. You think it’ll go down past $140. You buy a put option contract for 100 shares.

• Expiration date: 1 Month from Today

• Strike Price: $140

• Premium: $35 ($0.35 per share x 100)

The genius you are was correct. A month later, Boeing is at $135. Now, this is where put options are a little more complicated. A put gives you the right to sell the shares at the strike price to the writer. This means you buy 100 shares at $135 of Boeing and immediately sell them to the writer for $140 (strike price). You profit $465 ($5 per share at 100 shares, minus the $35 premium). 

Side note* you don’t actually need to buy or sell the shares of option contracts yourself. When exercising, that’ll be done near instantaneously technically using a margin loan if needed. There may be a commission when exercising, check the fine print.

Does this sound too easy?? With everything money, the devil is in the details. The fundamentals of options are as simple as it sounds. However, if someone is willing to write an options contract, that generally means they do not believe it will be exercised. The writer thinks they will get the premium and never hear from you again.

When buying an options contract, the most you can lose is the premium. Your risk is limited. When writing an options contract, the seller has unlimited risk as the stock could increase far beyond the strike price. Their gain is limited to the premium.

The details of options contracts from the premium to the expiration date are written to balance the risk.

Buying options these days is so easy that two dudes can do it while sitting in a Sonic parking lot. That means there are professional investors willing to pry on innocent, naive, tater-tot eating retail investors trying to learn a thing or two. They will collect your premium then buy overpriced tater-tots from some crowded bar in SoHo trying to impress a very uninterested woman.

Call to Action

If you are going to dabble in options, don’t do it alone and don’t spend your life savings on it. Grab a friend, buy it together, and expect to lose the premium. I promise you’ll still have fun.

What We’re Reading (audiobooks count):

Red Handed: How American Elites Get Rich Helping China Win. If you are tired of hearing politicians claim so and so is funded by China without knowing what that actually means, this book is for you. It details in astonishing depth how China has funneled money into politicians hands to achieve their long term objectives. If you’re a Republican, you will love it. All the Democrats are corrupt. If you’re a Democrat, you will love it. All the Republicans are corrupt. If you’re an optimist, good luck.

Debrief on Deck

Next week, Mike talks about Private Equity. Is it Private? Very much so. Is it Equitable? That depends on your perspective.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media: Instagram.

Until then, stay the course.

Disclaimer