Foundation of Options Trading and Investing
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|Section 2: Foundation|
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|Section 3: Options Trading Strategies|
Australian Investment Education goal is simple – to empower you with the education, tools and confidence you need, to put to work option strategies in the market place.
Over the years, we have had the privilege of working with tens of thousands of traders and investors, just like you, and helped them develop and apply their knowledge of options strategies to the market.
Practical Trading Strategies
We have successfully built profitable partnerships with our clients because our coaching is not based on theory alone. We are about practical trading strategies that equip you to respond to the market in real time. The core of our training program is results driven, as a result our options strategies are based on what is actually working in the market right now, rather than the “theory” of what could work.
Our team has extensive experience with more than EIGHT active decades of trading knowledge spread across our team. Our experience goes beyond options trading strategies, in that last 19 years we have worked alongside, coached and empowered both novice and experienced traders to successfully trade the markets.
Keep it Simple
Our entire approach is based on two things – Keep It Simple, and then Get You Doing It. All too often, people attend seminars, webinars or read a book, learn something but never actually apply that knowledge and turn it into profit. Our non-jargon, plain English communication with our clients demystifies and really breaks down successful options trading to its raw component parts.
Support on your Journey
What is unique about your education program is that it is carefully structured; to ensure that you get started and to ensure we are with you at every step of your trading journey and beyond. Providing you with up-to 13 different options trading strategies as well as the necessary help, support and real world tips on how to apply your new knowledge and turn it into profit.
Trading with covered calls is our foundation options strategy, which we use to assist our clients in generating “up front” income on a regular basis. As a trading and investing strategy, it ticks all the right boxes. What’s more, it is a proven outperformer
The potential for outperformance
The potential for outperformance is by far and away the key, when selecting the right investment strategy for you. Through our tools and recommendations, we trade covered calls on both the US and Australian markets, all from one account, providing our clients with the seamless benefits of both.
The strategy consists of two steps, and is process driven – meaning that consistency of results over a prolonged period of time is certainly achievable. The first step is buying the stock, in block so 100 shares on larger stocks – typically blue chip shares – as well as Exchange Traded Funds. Once purchased, the trader then looks to sell a call option over the stock, in order to earn a premium or income.
Typically, we look at a time from of 20 to 180 days for this strategy. In addition, our outlook for the underlying shares or ETF is typically flat to mildly bullish. This is a critical step and it is important to make sure that your outlook is consistent with this strategy.
Reduce the overall risk on the trade
The income or premium earned from the covered call may go toward lowering the average cost of the underlying shares and therefore reduce the overall risk on the trade. As such, it does provide some downside protection for the investor, but this is limited to being the income or premium earned.
The covered call investor profits form a move up in the underlying share price or ETF, although this is capped at the strike price level sold, as well as the income or premium earned from selling the call option. Similarly, if the price of the underlying instrument stays flat, the premium income is retained, and so is the underlying stock, leaving the investor with the ability to repeat the process over again, adding more to income earned.
A further bonus, which we also like to target, is additional income from dividends received, providing an extra value add for the investor tapping into this powerful cashflow strategy.
Immediate and up-front Income
Covered Calls are a cornerstone in our trading and investing philosophy, providing the ability for the investor to earn, on a more regular basis, immediate and up-front income. What’s more, they also provide great flexibility for the trader, as the strategy can be applied in a more conservative fashion, for the risk averse, or indeed may be tuned up to suit the more adventurous trader – the choice is yours!
At a more advanced level, by selecting bearish instruments such as Short ETFs, the strategy enables the investor to be profiting from a falling market, while also simultaneously earning income from the sold call component – an extremely useful diversification tactic that still earns an up-front income.
While more capital intensive than many strategies, covered calls tick the major strategy boxes and as such, should represent an important chunk of most traders and investors’ portfolios. By following some key rules, consistency of process should enable regular cashflow and premium to be generated against a backdrop of various market conditions over the medium to longer term 1 to 6 month time frame.
Credit Spreads are a more advanced options trading strategy that involve the use of options in combinations.
Credit spreads offer an up-front income, for the trader looking to capitalise on a variety of different conditions, be that a rising, falling or sideways market. This kind of flexibility can enable the options trader to capitalise on virtually any market conditions.
At their core, credit spreads require the selling of one option and the purchase of another in other words they are a two legged strategy.
The Income Generating Aspect
In order to create the credit, the option that is sold, is always nearer the current share price. The reason is that it will be worth more, in terms of the premium income generated, than an option that is further away from the current share price. As such, the sold leg of the trade is the income generating aspect of the strategy.
Option Only Strategy
Credit spreads are an options only strategy – in other words, there is no stock transaction involved. As a result, by selling the option, without owning the stock, we are in a naked or uncovered position – something which is risky.
To offset the risk, and provide the investor or trader with some protection, the second leg of the strategy is to buy an option.
The option purchased will be further away from the current share price, than the sold option, therefore costing less to buy. As a result of this, the income from the sold option would be greater than the cost of the bought option, creating the credit on the trade, and hence the income. What’s more, by purchasing an option, as protection, the risk on the trade is both limited and defined up front, enabling the trader to make an informed decision as to whether they wish to participate.
Being an options only strategy means that credit spreads don’t require a massive trading bank, to utilise the strategy. What’s more, the strategy can be applied to either calls or put options, enabling the trader the potential to profit from either a rising or falling market.
Spreads can offer a get out of jail step too, if the initial trade has moved against you, and this is known as “rolling”. While from time to time, we may utilise this, it is not an approach we actively use.
One of the many attractions for the credit spread options trading strategy is that the overall risk of the trade is known at the outset and up-front, enabling an informed decision to be made and the risks evaluated. Spreads can also give the trader time to decide, which can be a great advantage over a knee jerk reaction to simply close a position.
Typically, the strategy is applied on a short term view in the order of up to 45 days. However, at all times, the account should have more than enough excess cash to cover the trade position size ie the difference between the strike prices multiplied by the number of contracts. Once mastered, call and put spreads can be used in combination, to create a range of advanced strategies such as iron condors, offering further benefits as bona fide options trading strategies.
Learning how this strategy works is surprisingly simple and certainly becomes very clear after a couple of trades – so always good to start small and learn from a practical perspective, how you can utilise this strategy as part of your trading plan.
The Calendar Spread is an options trading strategy that we utilise to assist in generating income up front, in a similar way to the covered call. However, with this strategy, this is achieved without actually buying the shares. What this means is that for the trader or investor with a smaller account balance, or that are looking at a more leveraged return on investment, the principals of our covered call strategy can still be applied.
A Two-Step Strategy
Like its un-geared cousin, the Calendar Spread is a two-step strategy. Instead of buying the stock – typically a larger more liquid blue chip share or Exchange Traded Fund, the trader purchases a longer dated call option, providing a different type of underlying that we can then sell call options over. The typical maturity of the bought call is in the 6 to 8 months to expiry, providing the ability to hold the call option for 3 or 4 months before the severe time decay kicks in and erodes the option’s value.
At the same time as buying the longer dates, we simultaneously selling the short dated call. The basis for this is that we are looking for immediate income, from the premium earned from the sell (as with the covered call). We also are looking for the time decay to eat away at the short dated call, with it expiring worthless. From there, we re-sell a short dated option for the next month, again generating immediate income.
Should the share price run up hard, we can close out of the position, with our purchased long dated call worth more than what we paid, giving us a banked profit, in addition to the premium income we have earned from the sold calls.
Typically we would look to close this position with 3 to 4 months left to run on the longer dated option, avoiding the worst of the time decay, which will begin to kick in, during the last 2 to 3 months of that option’s life.
Advantage of Calendar Spread
The massive advantage to this strategy is that it requires substantially less cash than a covered call, given the comparative lower cost of buying the call option instead of the stock. This then opens the door to option income earning to those investors that are starting with a smaller account balance, enabling them to also participate in cashflow trading. Equally, for those investors looking for cash extraction (being able to get their cash out of the market but still maintain some exposure), the strategy provides market exposure with far less cash exposed to risk.
The Calendar Spread offers great flexibility – making it very attractive. Depending on the selection of the bought call, the investor can chose to have a more or less leveraged exposure in the trade. What’s more, by requiring less cash, compared to owning the stock, several positions across a variety of stocks may be held simultaneously, providing an opportunity to lower portfolio risk through diversification.
Short Version of Calendar Spread
From time to time we operate a shorter version of this strategy – trading options with less than two months to run, enabling extremely low cost exposure to the market, with leveraged upside.
Because a long dated call option is typically far cheaper than buying the shares themselves, we often refer to this strategy as our replacement covered call or “V8 strategy” given the leveraged returns available. As such, the Calendar Spread is a key tool in our approach to successfully trading the market given the number of significant benefits provided for the trader, particularly where the trader’s timeframe is around the 30 to 90 day mark and income generation is the goal.
Stock Repair is arguably one of the most valuable trading strategies that most people have never even heard of! In a nutshell, stock repair provides a mechanism for trading out of shares that are currently under their purchase price, for break even – even without the share price recovering to the entry level! As such, the strategy can provide an extraordinary level of value add for the savvy investor and hence why it is a key tool in our trading approach.
Stock Repair Strategy
When buying stocks, the key risk is that you are wrong, and the price drops. If you are not stopped out of the trade and continue to hold the position, the great temptation is to average down (something we never recommend). Instead, let’s look at how through some deft options trading, the trader or investor may be able to walk away with a small profit, even if the shares don’t get back up to your entry price. If calls have already been sold, then at least the income earned may go some way to softening the blow, but there is more that can be done and is available to the educated trader.
Stock repair, effectively is made up of a ratio spread that is constructed over the top of the existing stock position. This process involves a purchase of call options, to enable the position holder to leverage up to any bounce back up in the stock price (better than using a whole lot of cash to average down the position). The quantity of call options bought should match the original number of options sold. For example, if the trader is holding 800 shares, they would now buy 8 new call options. Given that these new purchased call options will cost the investor money, how can we offset that, effectively making the new position a zero cost?
Double the Number
In this instance, we sell double the number of calls, than what we purchased. These will be at a higher strike price – and hence will earn less than the purchased calls which may be at the money. The reason we can sell double the calls (16 contracts), is that we also own the stock, and effectively the entire sold position is covered half by the stock (800 shares) and half by the (8 contracts) purchased calls. Nett effect is that the new strategy should cost close to zero to enter and the leveraged exposure and profit from the bought calls will help offset the selling of the stock at a new lower than entry, break-even price level.
Stock repair is often referred to as a “Get out of jail for free” card. It is easy to see why, as the investor may be able to exit the position, at a price lower than they entered, yet still break even or possibly make a modest profit. How – though mastering options trading and harnessing the powerful elements that these derivatives bring to the table – leverage, time to decide, income and flexibility. All the trader needs to bring is the knowledge and confidence to apply the strategy at the right time, and suddenly the investing and trading world has a safety net, should things get a bit sticky!
Buying put options is a very simple and straightforward options trading strategy for the trader and investor who believes that the underlying stock price is going to fall in value. Specifically, the more the underlying price falls, the more the value of the put option increases.
Buying a put is a way of gaining a leveraged exposure to a move down in the price of the underlying shares or index.
There are two primary reasons why a trader and investor may buy a put. One is for risk management and hedging, the other, for more speculative purposes.
Starting with the hedging or risk management view, if a client owns shares and is perhaps concerned that the price may be shaping up for a period of weakness, but doesn’t want to sell out of the stock, they may instead buy some puts as a form of insurance. Specifically, the owner of a put option has the right, not the obligation to be able to sell the underlying shares at the strike price of the option.
Imagine if you had BHP shares and also bought a $36.50 BHP Put, when the shares are currently $31. Having the ability to sell your shares for $5.50 more than their market price would have to be a great outcome! Very handy – particularly if the share price has fallen heavily.
In this instance, we tend to buy longer dated puts, so as to avoid the pain of time decay. Typically, this is how most portfolio and share investors utilise puts. In more challenging times, this can be a massive bonus and one that also provides peace of mind to the investor. One thing to be very clear on, there is a huge difference between buying and selling put options and the risk associated with either side of the trade!
Unlimited upside potential
From a more speculative perspective, the reason for buying put options is that your view on the underlying stock would be that you expect it to go down in value. The more the underlying goes down, the more the value of your put options will go up, offering an unlimited upside potential, if the underlying stock falls!
Providing the ability to make money from a fall in the market is a strong reason for utilising puts, given the opportunity for profit in this scenario. Like calls, puts also bring with them leverage and the need for only a relatively small trading bank.
While your risk is limited to the outlay, one hard and fast rule should never be to hold a bought position to expiry. Given the leverage factor, which works for you, if the trade is correct, this will work against you if your view is wrong, and the trade moves the other way. As such, having a stop loss, based on the price of the underlying instrument is critical to your trading success. Time decay is also a factor which negatively impacts a put options trade.
Depending on your strategy, buying a put can be used as a risk management tool or as a speculative tool, where the trader and investor has a bearish short term view – from 1 to 60 days, being the typical time frame. It offers a variety of key advantages including a leveraged return, small capital requirements and in-built risk management. Put options are one of the key building blocks on which you will build your trading and investing business, particularly when used as a component of your strategy.
Buying call options is one of the most straightforward options trading strategies available. Straightforward, of course, doesn’t mean ineffective, in fact, quite the reverse. Buying a call is a way of gaining a leveraged exposure to a move up in the price of the underlying shares or index.
The reason for buying call options is that your view on the underlying stock would be that you expect it to go up in value. The more the underlying goes up, the more the value of your call options will go up, offering an unlimited upside potential, if the underlying stock skyrockets higher!
The advantages of calls
Calls bring with them a wide range of advantages for the trader and investor. One of the major attractions is leverage. When a call option is “in the money”, its price moves directly in line with that of the underlying share – the benefit to you is that you probably bought the option for cents, rather than multiple dollars, providing the potential for a substantial return on your investment.
Additionally, buying a straight call option does not require a large account, as the cost of the option is only a fraction of that of the underlying shares, enabling for a diversified approach to the market through multiple low cost holdings. This low cost also means that the strategy can form part of a “cash extraction” strategy – in other words, you may be a little unsure of the market, and as such sell all your holdings down. However, with a small allocation of your money – cents in the dollar – you may be able to maintain exposure to the market, and de-risk your portfolio through holding calls instead of the stock you have sold.
Know your maximum risk
Holding a call option enables the trader and investor to be fully aware of their maximum risk at the outset of the trade, as this is defined up front – at its maximum, the capital used to enter the position. This is unlike other derivatives, where the risk can be almost unlimited and certainly far more than the initial cash outlay, hence why we prefer to use options for trading and investing.
Naturally, like all investment and trading instruments, there is some downside to buying calls. While your risk is limited to the outlay, one hard and fast rule should never be to hold a bought position to expiry. Given the leverage factor, which works for you, if the trade is correct, this will work against you if your view is wrong, and the trade moves the other way. As such, having a stop loss, based on the price of the underlying instrument is critical to your trading success.
The other significant risk on trading the bought option is “time decay”. Time decay is a function of options pricing – when an option is launched, it has a value, and at expiry, it has none. Each day, the value of the time component of the option will diminish – particularly as the option gets closer to expiry. This must be managed correctly, in order to avoid the problem of holding onto an asset which is effectively worthless. While this is a risk to the buyer of the call, it is precisely what we are looking for, when selling covered calls, hence stacking the deck in our favour.
Short term bullish view
Buying a call is a speculative strategy, and typically used where the trader and investor has a bullish short term view – from 1 to 60 days, being the typical time frame. It offers a variety of key advantages including a leveraged return, small capital requirements and in-built risk management. However, as a strategy, it is one that we rarely use in isolation, given some of the drawbacks on the strategy. That said, call options are one of the key building blocks on which you will build your trading and investing business, particularly when used as a component of your strategy.
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Andrew Baxter the founder of Australian Investment Education grew up in a working class household in the United Kingdom. From an early age, his parents encouraged him to “work hard at school and get a good job”. He graduated from one of Europe’s leading business schools with a Bachelor of Science Honours Degree.
With a keen interest in investing from an early age, his career took him to the hub of global investment markets, the City of London. It was here, that a keen interest became the foundation for his success and over the next six years, working with some of the largest institutions, he built up a broad based expertise in trading and investing across global markets.
In 1999, he moved to Australia as an overall lifestyle change, where he continues to combine his passion for trading and empowering every day people to master the skills and confidence to successfully tackle markets.
Andrew’s business interests span across a range of organisations. He is an owner and Director of stock broking firm, Halifax Investment Services, which is one of Australia’s largest boutique broking firms. He is also the owner of leading trader educator and mentoring organisation, Australian Investment Education and advisory service, The Daily Wealth Report.
Andrew Baxter is a highly regarded key note speaker across a wide range of topics within the trading/investing and trader mindset space. Andrew has spoken alongside some of the world’s leading names, including Robert Kiyosaki, Anthony Robbins, Sir Richard Branson and Tony Blair.
Andrew has spoken to audiences for the ASX, Australian Financial Review, Australian Investors Association and the Technical Analysis Association, and overseas at the highly prestigious National Achievers Congress.
Always mindful of his humble roots, he is a dedicated philanthropist, and his organisations have helped thousands of people enjoy a richer life, establishing The Emily Lowther Foundation For Good, in honour of his Grandmother. Some of the causes supported include Rotary, Basket Brigade, World Vision, Magic Moments and Surf Lifesaving Australia.
On a personal level, Andrew loves to combine his passions of Travel and Photography. He is currently working on an exhibition of his work, the proceeds from which will go toward supporting his foundation. Andrew is one of Australia’s most sought after speakers in the trading and investing space, speaking to tens of thousands each year.