 |
|||
| |||
 |
 |
 |
 |
|
|
| ||||||||||||
| ||||||||||||
|
Option Trading Basics
Options trading can increase the profits you make when trading Stocks if you understand how to use them and know what you are doing. Options can be a very useful tool that the average investor can use to enhance their returns. This article - Options Trading Basics, looks at what options are and discusses some of the options trading strategies traders can use with these versatile instruments. Options - An Overview Options give the buyer the right, but not the obligation, to buy (a call option) or sell (a put option) the underlying Stock or futures contract at a specified price up until a specified date. In other words, options are like tradable insurance contracts. An investor can purchase a Put option as insurance against a decline in the Stock price or a Call option in case the Stock rises. Buying an option gives the purchaser time to decide whether they will buy or sell the underlying Stock. The price is locked in until the expiry date, which in the case of LEAPS can be years into the future. Options trading has several advantages that every Stock Market investor should be aware of, such as high leverage, lower overall risk than owning the physical security, more versatility and the ability to generate extra income from a current Stock portfolio. An option's value fluctuates in direct relationship to the underlying security. The price of the option is only a fraction of the price of the security and therefore provides high leverage and lower risk - the most an option buyer can lose is the premium, or deposit, they paid on entering into the contract. By purchasing the underlying Stock of Futures contract itself, a much larger loss is possible if the price moves against the buyers position. An option is described by its symbol, whether it's a put or a call, an expiration month and a strike price. A Call option is a bullish contract, giving the buyer the right, but not the obligation, to buy the underlying security at a certain price on or before a certain date. A Put option is a bearish contract, giving the buyer the right, but not the obligation, to sell the underlying security at a certain price on or before a certain date. The expiration month is the month the option contract expires. The strike price is the price that the buyer can either buy call) or sell (put) the underlying security by the expiration date. The premium is the price that is paid for the option. The intrinsic value is the difference between the current price of the underlying security and the strike price of the option. The time value is the difference between current premium of the option and the intrinsic value. The time value is also influenced by the volatility of the underlying security. Up to 90% of all out of the money options expire worthless and their time value gradually declines until their expiry date. This clue offers traders a very good hint as to which side of an options contract they should be on...professional options traders who make consistent profits usually sell far more options than they buy. The option contracts that they do buy are usually only to hedge their physical Stock Portfolios - that this is a powerful distinction between the punters and small traders who consistently buy low priced, out of the money and close to expiry puts and calls, hoping for a big payoff (unlikely) and the guys who really make the money out of the options market every month, by consistently selling these options to them - please think about this as you read the remainder of this article. The seller of the option contract is obligated to satisfy the contract if the buyer decides to exercise the option. Therefore, if he has sold Covered Call options over his Shares, and the Stock price is above the option strike price at expiry, the option is said to be in-the-money, and the seller must sell his shares to the option buyer at the strike price if he is exercised. Sometimes an in-the-money option will not be exercised, but it is very rare. The option seller (or writer) has to be prepared to sell the Stock at the strike price if exercised. He can always buy back the option prior to expiry if he chooses to and write one at a higher strike price if the Stock price has rallied, but this results in a capital loss as he will usually have to pay more to buy the option back than the premium he received when he originally sold it. Many option writers simply get exercised out of the Stock and then immediately re-buy more of the same or another Stock and simply write more call options against them. The buyer of an option has no obligations at all - he either sells his option later at a profit or a loss, or exercises it if the Stock price is in-the-money at expiry and he can make a profit. The vast majority of options are held until expiry and simply decay in price until there is no point in the hapless buyer selling them. Very few options are actually exercised by the buyer. The vast majority expire worthless. Having said all this, lets look at an example of how to use options to gain leverage to a Stock price movement when the trend does go in our favour... For this example we will use MSFT as the underlying security. Let's assume MSFT is trading for $24.50 a share and it is early January. We are bullish on this Stock and based on our technical analysis we think that it will go to $27.50 within two months. In this example, we will ignore Brokerage costs, but they do have an effect on the percentage returns. The prices and price moves of the Stock and the options are hypothetical - they are intended as a guide only. Buying 1000 physical shares will cost $24,500 and if we sell our position at $27.50 a share, we will make a profit of $3,000 or a 12% return on our capital. We will have $24,500 at risk if we take this position for a potential of 12% or $3,000 profit. Instead of using cash to buy the physical Stock, we can buy 10 call options with an expiration that is at least three months into the future and a strike price that is close to current price of the underlying security. 10 contracts represents 1000 shares of the stock, a call option is bullish, three months until expiry gives us some time for a quick move, and buying an option with a strike price that is close to the current price of MSFT allows us to get the full potential of the intrinsic value. We buy 10 MSFT $22.50 April Call options. These options are currently selling for $2.80 and they are in the money. $24.50 (the current price of the Stock) minus $22.50 ( the strike price) is $2.00, which is our Intrinsic value. $2.80 (the option premium) minus $2.00 (the Intrinsic value) gives us $0.80, which is the Time value. If the price rallies to $27.50, as we believe it will, the intrinsic value of these same options at that point will be $5.00 ($27.50 - $22.50). That means that if the Stock gets to $27.50 a share, our option premium would be at least $5.00 plus a small amount of time value, depending on the remaining time until expiry. Ten option contracts will cost us $2,800 ($280 times 100) and if MSFT goes to $27,500, we could sell our option contracts for at least $5,000 ($500 by 10 contracts), maybe more. We will have $2,800 at risk if we take this position, rather than the full price of the Stock ($24,500) for a potential of 80% or $2,200 profit, plus whatever time value is left in the option, probably another $100. Our options buying strategy gave us a much larger percentage profit with a much smaller potential risk. Don't forget though that, for us as the buyer, these options will expire worthless if not sold or exercised by the expiry date. The option seller or writer simply has to sit back and wait until expiry to see if he is going to be exercised. If the Stock price is below the strike price at expiry, he keeps the premium and can write another option over the same Stock. If the Stock price is above the strike price, he will most likely be exercised and will have to sell his Shares if he doesn't exit the position by buying his options back on the open market (quite often at a higher price than he originally sold them for). The downside of buying the option over the physical Stock is that if you bought the Stock itself, even if the price had not moved, you would still own it, but by buying the option, if the price doesn't move in the desired direction, you lose part of your trading capital. To make options trading work, the underlying security must move fairly quickly in the direction you expect, or you will lose money at an ever increasing rate as the expiry date draws nearer. As you can see, options strategies can offer much higher percentage returns with less risk for the same trade. The majority of your cash is still safely in your trading account rather than being exposed to the market. This is just one example of using options trading to increase your Stock Market returns. There are many more strategies and ways to use options and I encourage you to explore them further. All options expire worthless if they are not in-the-money at expiry, so the buyer must close out or exercise his position on or before the expiration date or he will lose the entire premium. The time value portion of the option premium decreases gradually until expiration date. The closer to expiry, the faster the time value reduces, as there is less time for the option to move in the desired direction for the buyer. For buyers, top traders advise never to hold an option with less than 30 days to expiry due to the exponential rise in time decay during this period. For sellers, it is usually most profitable to write options that have 30 days or less to expiry, due to this same time decay effect...the buyer of these options has the odds stacked against them and will require a large price movement in his desired direction to make a profit - remember, the vast majority of options expire worthless - so this is the side of these instruments the wealthy usually find themselves on - just a thought... There are many other intricacies of options trading that investors and traders should be aware of. This article is only an introduction to options trading and there is a lot more information for you to learn. For a more in-depth look at the various Options strategies available, visit AcornTrader.com. This page has a series of articles on options trading and outlines some of the strategies traders can use to profit from these extremely flexible vehicles. We encourage you to study these instruments carefully if you decide to trade them. Then use the trend trading strategies outlined in these stories and articles to position yourself on the right side of the market - whether as a buyer or a seller. To Your Trading Success, Tony Spann and Stock Trading Review Team Stock Trading Review is dedicated to helping you succeed as a trader by sharing with you simple and easy to follow tips and techniques. Discover more insider secrets and the exact proven strategies to trade stocks profitably: http://www.stocktradingreview.com Copyright(C)2005 Stock Trading Review
MORE RESOURCES:
Stocks-Mutual-Funds - Google News |
|
|
|
RELATED ARTICLES
No Load Mutual Funds: Investment Hype vs. Investment Help With the internet such a huge part of our daily lives, many investors have access to a wide range of instant investment information.Whether you're into stocks, bonds, mutual funds, futures or options, there are tons of electronic investment newsletters offering to turn your small stake into a giant fortune. Stock Trading Secrets? How often have you come across an advertisement or e-mail proclaiming to "teach" you the stock trading secrets that Wall Street Insiders don't want you to know? Usually included in the descriptions of these trading products are claims such as "Make 10K monthly in minutes per day", or "Learn the secrets of Professional Stock Brokers", etc. etc. Buy Low - Sell High Now where have I heard that before? I know. It was my broker. Psychology - How to Reduce Negative Thoughts Relating to Trading? The thinking process of the brain relating to the psychology of trading involves:-- Beliefs -- Feelings -- Values -- Dispositions and -- FaithThe positive or negative energy brings power to a person's actions, which ultimately determines whether a person is a winner or a loser. You can change for the better or for the worst. Patterns The Law of Chaos is the theory of random unpredictable action applied to the cosmos, mathematics, mechanics, almost everything. Those who believe it will definitely think the stock market is in chaotic state at this time. Good News? As the man said, "I've got some good news and I've got some bad news. What do you want to hear first?" It was replied, "Tell me the good news first". Pathways During our travel down life's path we come to many places where the trail divides and we must make a decision. Some involve psychological (emotional) choices - marriage, divorce, leaving home, career changes, etc. Emotional Involvement I'll bet with almost anyone that has stocks or mutual funds in his portfolio that he has losers, but he won't sell them because he "likes them" or some similar excuse. This is the philosophy of a loser. The Great Stock Market Secret When the stock market is going up and all your stocks and mutual funds are making money you feel like a genius. It is too bad that some folks don't remember what happened in 2000. Price to Earnings Ratio - P/E After finding the price of a particular stock, usually the next number everyone looks at is the P/E ratio.P/E is the ratio of a company's share price to its per-share earnings. How Much Money Can I Make With Trading? What Account Size Do I Need To Start? What account size do I need?How much money can I make with trading?First of all, let's clarify a common misunderstanding: You never risk your full account size. You always have a "catastrophic stop", and it is important to define the "ruin" before you start trading. Hot Stock Investing ... How to Pick Hot Stocks with Momentum Stock Trading Profitable day traders recognize that momentum trading is among the fastest & most effective ways to harvest BIG piles of cash in the stock market.The problem is that if you don't know what stocks to look for and how to approach them while limiting your risk, you won't even get close to making some profits. The Right Mutual Funds For Baby Boomers If you are a baby boomer, time is not on your side. Many baby boomers see retirement age fast approaching with little to nothing in the way of retirement assets that will allow them to actually retire and live a comfortable lifestyle. Why the Majority Fail at Stock Investing The gleam and bright lights of Wall Street lure in many new investors each year, only to send them home crying to their friends and family. Why do so many people fail when it comes to the stock market? The reason is very simple: Hard work! Most people are looking for a quick buck or a fast path to riches. Why This Bear? People are constantly asking me why is the stock market going down. What is causing this bear market? It is relatively simple so don't ask an economist. Investment Attorneys and Garbage Stocks How is it possible that trash Companies are posting less than expected results? Trash Companies are thought of by prudish investors as some of the safest stocks to own. Ask Warren in his Buffet of Essays on Corporate America. Paddle Your Canoe At some time in your life you have been on a river in a canoe and hopefully you had a paddle. You know about being up the creek without one. Market Psychology Today we are inundated with tons of information about the economy, stocks, government agencies and foreign governments. They show us charts and graphs of the increase/decrease in oil production over the last 5 years, the amount of maple syrup produced in Vermont for the past century, the time it takes to bounce a signal off the moon and all kinds of other nonsense that we can live without. The Stock Market Investor's Worst Enemy Every stock market investor faces one primal enemy. An enemy so perverse, it will drive thousands of investors from the stock market through its ability to defeat even the most practiced investment strategy. Investment Discipline One of the great "secrets" of successful people is discipline and it doesn't make any difference whether it is manufacturing, processing, servicing or investing in the stock market.Before you can have that discipline you must have a successful plan and stick with it.
|
| home | site map |
| © 2006 |