trading options laptop

A Real, Profitable Example of Trading Options

Trading options is more popular now than ever. Recent findings show that the entire derivatives market is over four quadrillion dollars. New investors that start trading options can quickly find themselves in a world of hurt. If you don’t know what you’re doing, you can lose a lot of money very quickly.

The good news is that some strategies come with a minimal amount of risk. Some of them, like mine, is a good source of extra income when buying and selling stocks.

In my previous post, I explained my strategy for trading options using a theoretical model. This post is to show the details of an actual trade I made using this strategy.

If you need a refresher on how options work, check out my previous post.

Picking the Right Stock

My strategy involves selling options and taking the premium as profit. The catch: you can only do this on stocks that you want to own or currently do own. And each option contract uses 100 shares of stock as the underlying asset. This means that if you want to participate in this strategy, you need to pick the right stock.

Generally, I subscribe to the Warren Buffett strategy of picking stocks. I buy wonderful companies that I would be happy to hold for a long time. Using the profitability of a company, its expected growth rate, and its historical P/E ratio, I will come up with a target price to buy. At this point, my process is more of an art than a science. Perhaps in another post, I will detail out my thought process when pricing a few stocks.

For this trade, I bought HanesBrands Inc. (HBI). This stock is one of my favorites for this type of trade for a few reasons: (1) it’s a well-run and stable company, (2) it pays a good dividend, and (3) the stock price is low. A low stock price is important in these trades if you’re not working with a ton of money. I’ll show you why later.

Waiting for Your Moment

After I knew which stock I wanted to buy with this strategy, I just needed to wait for my right moment. Then came November 5, 2020. On that day, HBI dropped 20%. I already owned some HBI shares, and I lost a lot of money on that day. But that’s nothing to worry about. I am confident in the long-term success of the company, so the short-term volatility won’t scare me away. When this happened, I even made a joke about it on Twitter.

On the same day as the 20% drop, I sold a put option on HBI. Below is the screenshot of this transaction.

There are a few selections I needed to choose, so I’ll try to explain each one. From my previous research, my target price to buy HBI was $14. The stock price was already far below that, but I wanted to make sure I bought the stock. I entered into a contract with a strike price of $13.50.

I chose an expiration date of Nov. 6 to buy it as soon as possible. Since I was selling a put option (which gives you the obligation to buy), I selected the “STO” option–sell to open. This is what you select when opening a new position to sell an option. The quantity I entered was 1. 1 option will buy you 100 shares.

You are also able to select an order type: market, limit, stop and stop limit. For this strategy, I only use the ‘Limit’ option. Selecting the ‘Limit’ option guarantees that you won’t receive less than your desired amount for the option premium. You either sell it for the desired price, or the order is canceled. I usually use 2% of the strike price as my baseline. In this case, the strike price is $13.50, so I would accept nothing less than $0.27–premiums are priced on a ‘per share’ basis. I enter in this $0.27 as the limit price.

To do this trade, I needed some cash reserves. Since options contracts are backed by 100 shares of the underlying stock, I needed to have 100 times the stock price in cash. With a strike price of $13.50, I required $1,350 of cash reserves.

I submit this order, and thankfully, the contract sold for $29.35 after commission ($0.2935 per share).

The stock ended the week at $12.85. Ouch. I ended up buying 100 shares that were worth $1,285 for $1,350. Considering I also received money for selling the option, I actually ended up buying 100 shares of a $12.85 stock for $13.2065 each.

Seeing where the stock price ended up, I could’ve sold this option for much more if I waited. But that’s not too important. Even though my timing and price estimations were off in this case, I still end up making money.

Waiting Again

Now that I bought 100 shares of HBI, I needed to wait until the stock price increased, so I could sell it. In some cases, this can take a long time. That’s why you should only do this strategy with stocks that you really want to own.

In this case, it took about two months. The stock price for HBI was back above $14 and I wanted out of my position. On December 17, I sold a call option to sell 100 shares. I chose Christmas Eve as the expiration date and $14.50 as the strike price. Again, I chose the Sell to Open option with a quantity of 1 and a limit price of $0.15. This was lower than the 2% guidance from above, but I wanted to do it anyway. Like I said before, my process is more art than science.

When selling the put option, you needed cash on hand. When selling the call option, you need 100 shares on hand. I had that from the previous transaction, so I’m good to go. The contract settles for $14.35 after commissions ($0.1435 per share).

On Christmas Eve, the stock price was $14.59. If I add in the $0.1435 premium from selling the call option, I ended up selling 100 shares that were priced at $14.59 for $14.6435 (strike + premium).

Adding up all the numbers, I bought 100 shares for $1,320.65 and sold them two months later for $1,464.35. That’s a gain of $143.70–and 10.9%–in two months. Even though my timing and pricing left much to be desired, I still ended up with a great return.

If I ended up buying and selling this stock without trading options, I still would’ve made money. I would’ve bought 100 shares for $1,350 and sold them later for $1,450 for a gain of $100, or 7.4%. That’s still a good return.

With options, I was able to make it even better.

Conclusion

This trade ended up being very profitable for me. As I write this, the stock price is over $15, so it could’ve been even better.

It also could’ve been worse. There is no guarantee that the stock price of HanesBrands would increase during this time. It might have even gone lower.

But I was confident in my choice. I analyzed the fundamentals of HBI and I knew that they had a solid financial foundation. If all things kept cruising along the path they were on, I believed that the stock price would be above where I bought it sometime.

For anyone looking to buy or sell 100 shares of stock, trading options with this strategy can be a great way to make a little extra.

Thanks for reading!

Featured photo source: MayoFi on Unsplash

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