stocks and options from 30k feet

One of my friends at work asked me if I had any book recommendations for learning about stocks and options. Mentally, I break trading down into two general classes of trading: index-type and “exotic” trading. By exotic trading, I mean picking individual stocks/options and actively trading. This runs counter to the more conservative buy-and-hold, index-based, hands-off approach.

For the exotic trading, I learned most of what I know from a class with Professor W.E. Olmstead and his book, Options for the Beginner and Beyond: Unlock the Opportunities and Minimize the Risks. For the option-uninitiated, the basic idea is that instead of buying or selling stocks directly, you buy and sell contracts that give you the right (but not obligation) to buy or sell the stock at a particular price by a particular date. That’s a mouthful and options are indeed subtle beasts, but they allow the flexibility to either hedge risks you want less exposure to, or increase/leverage exposure to risks you do want to take.

Here’s one pretty basic example, called the “Covered Call” strategy. Suppose you:

• buy 100 shares of SQ (currently trading at $11.12 per stock share or $1112 total)
• sell 1 DEC16-16 $13 SQ call contract (currently trading at $.25 per option share, or $25 per contract)

You get the $25 account credit when you sell the initial shares; your eventual profit vs loss on this trade breaks down as follows:

• if the stock price is above $13, the option is likely to be exercised, which means you will be paid $13 per share for each share of the contract ($1300 overall) and the counterparty takes ownership of the shares.
• If the stock price is below $13, the option is likely to stay unexercised, so you keep the 100 shares of the stock and the original $25.

This sale can be repeated as often as the option expirations are available, which is usually every month. Exceptions happen in both directions, though: some (especially newer) stocks have less frequent option expirations, while some (extremely high-volume) stocks have more frequent option expirations – as often as weekly! Furthermore, in the unexercised case, you don’t need to buy the stock again since you still have it from the last round. With enough iterations of this, one can even pay off the original stock purchase purely from writing the covered calls.

That’s not to say this is easy, though! If the market considered it impossible for the stock to go that high, nobody would buy the option contract. So the trick to this strategy is finding a stock and predicting the movement, and actually being correct.

As discussed above, you can use Google Finance to view the stock price history and the stock option price chain:

These quotes, however, can be delayed; most reputable option trading companies will provide an up-to-the-second view of the option chains.

Turns out that finding, predicting, and being correct are pretty hard, and a fair bit of distraction, though. So instead, I mostly opt for the boring route: investing in index funds and riding the standard stock-market growth curve. As best as I can tell, this is pretty close to the view espoused by Bogleheads.org(though I admittedly haven’t read the book): Invest a steady stream of earnings in an index fund with as low of management fee as possible, and let it ride as long as possible. Index funds are a kind of “synthetic” stock that tracks multiple other stocks. For example, QQQ tracks the performance of the Nasdaq-100 index, the DIA tracks the performance of the Dow Jones Industrial Average, and SPY tracks the performance of the S&P 500.

Disclaimers: The SQ stock quotes listed above are just illustrative examples and not trading recommendations, though I am long SQ as of the post date of this article.