Episode 02

Option Trading: Breakevens with JJ Kinahan

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In this option-trading education podcast, listen to JJ Kinahan, Chief Market Strategist at TD Ameritrade, and his guest panel discuss breakevens, a fundamental concept of option trading.

Audio Transcript

JJ: This is Understanding Options. I'm your host, JJ Kinahan.

Victor: Hello everyone I'm Victor Jones, director of trading at TD Ameritrade. Welcome to TD Ameritrade chief market strategist JJ Kinahan's podcast series, Understanding Options. Today JJ and I are joined by Kevin Hincks, Scott Connor, of our trader education team here, and Tom White from our affiliate advisory service, TradeWise.

JJ: Welcome Kevin, Scott, and Tom. Thanks for joining us to discuss our topic, the importance or breakevens and thanks Vic, for hosting buddy.

Victor: Yeah, happy to be here JJ. You had talked in a previous podcast about your early days at the Cboe and the importance of breakevens. I'm hoping you could kind of speak to that a little bit here.

JJ: Sure, and I think that these guys have all had similar circumstances. When I first started trading, I'll never forget, as I was heading down to the floor the first day the gentlemen who started me, they said listen, after six months, you've broken even, welcome aboard. If you haven't, it's been nice knowing you. And so what it really is about and that's something that I hope people take from this is, I know many of us, particularly when we first start out are like, look at how much money I'm going to make.

But the reality of people who've done this for a living is, what it's really about is defining your risks, keeping things small, keeping your trades small, and getting yourself to a point where you can learn how to stop losing money. And again, Kevin and Scott can talk a lot about this and Tommy, it's really amazing how you see the light bulb go on in people's heads when for the first time they've consistently stopped losing money. And the repetition of that, just like anything else, just like being a good golfer, having a good swing, repeating it, having good habits time after time.

Victor: Yeah and Kevin, we do a lot of work with college students. And one of the things that they always ask about, or we start to explain options to them. And the concept of breaking even, not necessarily hitting home runs, but really hitting for singles and how to manage a portfolio, portfolio risk using options. And you start to see the light bulb turn on. I'm curious, what are your thoughts about options and risk?

Kevin: Well, when you say the word options and risks, the first thought that comes to my mind is unlimited or limited, right? That's the difference between trading options and defining both, and understanding it. The more you understand risk, remember, every trade you make, no matter what it is, it's going to have some risk right? If you do probabilities you can do a 95% chance that an option will finish out of the money. Well that's not 100.

So there's risk there. You always have risk. Learning how to tame it and define it, and take advantage of-- risk is actually a good word right? Don't be afraid of risk, but understanding it through education, that's the key.

Victor: And especially for college students. I wonder, what are your thoughts? There's risk to not investing at all right? To not even participating in the markets.

Kevin: Sure. I mean, think about if you're 30 years old right now, and you got out of college in 2007, 2008 when the markets was at or near its lows. Think if you just invested a small amount of money back then on the long side of the market, how that would be now. And if you've just incrementally traded for the last 10 years, how that could have grown and grown. So yeah, missing out, not trading over a period of time. Absolutely.

Tom: I think dealing with options and the different strategies, the different risks, rewards that we're talking about involved in a lot of these trading. Kevin made a point about being defined risk, or not, undefined risk, and taking a directional bias. Here we can use an example of being bullish. You can buy a call vertical. You can sell a put vertical. You can buy a call calendar that's above the market. There's a lot of different strategies that you can do.

Creating a break even in a high probability trade is probably going to be beneficial for those newer traders, or those traders that want to get some more experience and be able to, as we always say sleep at night with these directional bias type of positions. But the different strategies that you can use to create a bullish, or bearish stance, or a neutral stance are out there. And you just have to get comfortable with those and be comfortable with your risk on the downside before you start doing the more difficult, or multi-legged spreads.

Scott: I'll add to that a little bit Tom, if you don't mind. When JJ opened up and talked about the importance of knowing breakeven. And I just want to emphasize the point that, oftentimes let's just take a strategy like buying a call option right? A call gives you the right to buy 100 shares. When people look at that strategy they tend to focus on like JJ mentioned, how much I can potentially make because it has unlimited potential gains. And so a lot of times the focus for them gets attracted to hey, what if a stock goes up $10 in the next month?

Well, when you step back and you say, well, where do I actually break-even? Well, I need the stock to get up to a certain point. Well, at that point you say, all right. Well, if I need it to get at least here what's the probability of that happening? And what it does, it kind of forces you to look at, not so much focus on what you can potentially make. But what could you reasonably make looking at probabilities in the time frame between now and the expiration?

Victor: Yeah. And not only how much can you reasonably make. But what is the risk, what's at stake in terms of risk? And Kevin, you made great points around risk. I'm kind of curious how can investors and traders determine if a strategy, you guys mentioned there's lots of different strategies you can pursue. But how can somebody get a feel for whether a strategy is low or high risk?

JJ: Well, what I would say is, it's going to depend on the person. And the more you risk the more you have the potential to lose. But the more you risk the more you should get paid for taking that risk. So if you're going to take a lot of risk you better have a heck of a lot of potential upside. If the trade doesn't have a lot of potential upside, it's probably a lower risk trade. And there's nothing wrong with that. Actually I think that most of us have made our careers, I always say, I want to be Pete Rose without the gambling. Single, single, single, single, every day of my life. And so consistently that these low risk trades add up.

And for really basic people who-- I shouldn't really basic. That's a bad choice of words. For people who are newer to the options game. Let's say it that. And are trying to figure out some of the more basic strategies, if you buy a call, you have the right to call or, 100 shares of stock. That's really how it gets its name. You can call that stock away from someone.

Again, you're paying a premium for that right, plus the transaction costs. So the most you can lose then is what you paid for that call option. So we'll say a stock's trading at $108 per share and you can buy the 105 call for maybe $5. You're risking less for the call compared to buying the stock. If you buy that call you're risking $500 plus your transaction costs. Whereas if you buy the stock outright, you're risking $10,800 plus transaction costs and on that stock.

So just like owning a stock my potential reward though, is that the stock has to move higher. The bigger difference is going to be that I have a limited time frame on my call, where theoretically I have forever on my stock. If I sell the call I'll collect that premium. But again, in this case, if I sell a stock theoretically the stock can go up forever. If I sell a call theoretically a stock can go up forever. Someone once said to me the only stocks that can go up forever would be the ones I sell.

But again, that's why we talk about doing spreads, et cetera, which will get more into in future podcasts. So we want to define what that upside can be if we sell something. So the risk for long call strategy is really straightforward. And complex strategies will often require software like our thinkorswim platform so people can understand the strategies. And as we like to teach, we've talked about it a lot. We continue to do it. We want to define risk as much as we can.

Victor: Yeah, just to reiterate. I think some of those key risks there is the breakeven right? That's what we're talking about here. Your breakeven for that call, and the bullish strategy is going to be potentially a little bit higher than it would be if you just bought the stock at expiration right?

JJ: And then my example was 110, 105, plus the $5, which was compared to 108.

Victor: But then you also have that other risk, which is time. You have expiration and therefore that's kind of working against you, versus buying the stock you have a longer time horizon. Time then is working against you in the particular situation. So that's one of the risks you mentioned as well. I'm curious, could you speak Kevin, to the potential rewards then?

Kevin: Of long calls right? I believe that's what we're on now. Well long calls are real simple. It is a risk defying strategy. So all you can ever lose is what you paid for the call right? If you're just long an outright call the upside is just, it's very romantic. Unlimited, it looks beautiful as it goes up into the night right?

But you have to understand the probabilities and the risks involved with that buying. Because many times if you purchased the wrong call at the wrong implied volatility, how many times have we gotten phone calls from customers saying, I was long calls, the stock went up, good earnings. How did I possibly lose money?

Well, understanding implied volatility right? Getting out of a long call, buying a call. If you time it perfectly, having the stock go up. Selling out the long call for a winner. That's great. And it's very simple. And it's easy. But it's all the other things that you have to worry about to make sure that that trade is right. That's what we try to teach at TD Ameritrade.

JJ: And one of the things Vic mentioned is the time risk. And I think it's really important to keep in mind, we've all been in this situation. You hold a call, and maybe, as I gave the example, earlier you buy a 105 call. For some reason the stock just has terrible news and it's trading at like $80. Well, why don't I sell that call now? Well there's no bid for it. Because it's so far out of the money, there's no one to sell it to. No one has a desire for it. So that is a risk.

You want to know where an options play breaks even at expiration obviously, as we just talked about. And again, for some strategies you can compute it really easily, if you need help, that's why we have the Analyze tab on the thinkorswim platform. Tommy, I don't know if you have any examples really quickly to help people understand that.

Tom: Yeah. So an example might be if we're looking at Apple's stock. We'll just use that as a quick example. We'll look at the May 140 call options on Apple. They're worth $4 for those calls. If the stock falls below that 140, the call is worthless at expiration right? But since one call controls 100 shares, and the multiplier's 100, your cost of one contract for $4 is going to be $400. That your entire risk on that particular trade. And that your breakeven. That 140 strike in May that you bought, you paid $4 for. What's your breakeven? It's the strike price plus the option premium that you paid, which is $4.

So your breakeven point goes up to 144 on that particular trade. And with a one lot, your breakeven, 144. And the nice thing about the thinkorswim trading platform is before you click that confirm and send and then send it again, it gives you that breakeven, that pop up box. And that's a great tool especially for new traders. When you're trying to figure out your breakeven points and maybe you don't want to do that quick math, you can click on that confirm and send button, the dialog box that pops up. One of the first lines up there is a breakeven point on that particular trade. So that's just a quick example of how you can get your breakeven points on a simple trading strategy such as buying a straight risk defined call.

JJ: And I think people, they have to take their transaction costs also into account there.

Tom: For sure.

Victor: And the examples you gave, it's a pretty straightforward run right? Buying a call, buying a put. And there can be other strategies that have multiple breakevens. But the point is all of those things just take some time to learn. And you have to start somewhere right? And the platform helps you to understand the breakevens very easily.

But again, just knowing that it could take a little bit of time. If you just chip away at it you become more proficient in the basic, intermediate, and more advanced strategies as well. And no matter what you're using the potential risks and rewards and breakevens can be defined ahead of time. I think that's one of the keys that Kevin mentioned earlier.

Tom: Right, and Vic makes a great point. Stay small when you're starting to trade these strategies. Stay risk defined, stay small, and be comfortable with that risk getting into that particular position. And then as you get more experience you're going to be able to do more and maybe take on some more risk.

JJ: I think it's important, you guys both mentioned that you learn what you can about options and so that you will understand what strategy to use in which situation, and what works for your risk tolerance. So the most important thing is knowing what strategies have defined risk and which ones have unlimited risk. That really is a whole lot of what this boils down to.

But anyway that will conclude today's show guys. Be sure to tune in for our next podcast on portfolio risk, which will be one that will be pretty exciting, and a lot to learn. You can find more about option education at EssentialOptionStrategies.Com. As always, you can find me on Twitter @TDAJJKinahan. As always, thanks to our crew Kevin, Scott, and Tom for joining us. Vic, thanks for keeping the conversation moving my friend. And of course, the biggest thank you to our listeners. We do appreciate you tuning in. We hope you enjoyed today's broadcast. And as always, good trading everyone.

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