Options Trading Guide
What is the difference between a stock and an option? Why trade options? Three major features when trading in options Ways to trade in options What strategies are employed when Option Trading? And FinallyNow, for most average punters, the way we go about investing in the stock market is by studying the history of a company, and what is the news about it. If we feel that the company is going places and subsequently its stock price will rise, we buy stocks in that company hoping to sell them later at a higher price than we paid for them, thus earning ourselves a profit. This is OK for the long term investor. However, for the short to medium term investor, this way of investing on the stock market does not utilize the full potential of his/her investment capital, and he/she would be better off looking for additional investment opportunities, one of which is trading options.
| What is the difference? | Top |
The main difference between a stock and an option is that when you buy stocks, you get to own a small part of the company whose stock you bought, whereas with options, you enter into a contract that gives you the right to buy or sell the stock at a specific price by a specific date. As with any type of contract, there are always two sides involved, and there is no difference with an options contract, where there is always a buyer and a seller. In other words, for every call or put option purchased, there is always someone else selling it. When someone sells options, in effect what they are doing is to create a new security. There are two different types of options:
- call options
- put options
Call options are purchased when you believe the price of the underlying commodity will rise, and put options are purchased when you believe the price of the underlying commodity will fall. When purchasing options, your maximum risk is the options premium. Premium, simply stated, is the price you pay for the option. Purchasing an option gives you the right to either buy (call) or sell (put) a certain commodity at a certain strike price. Strike price is the price at which the option gives you the right to buy or sell. At any given time there are various strike prices available to trade on an underlying commodity.
| Why trade options? | Top |
A When you trade options, you are able to choose a particular stock or sector movement for a defined period of time. The flexibility of the option trading system allows you to enter the market in that very direction and volume that you require in order to profit from the anticipated movement of the share price.
The advantages of taking part in the somewhat risky business of option trading include earning additional income, leveraging returns, hedging your bets, and getting more time for making decisions.
Writing call options against your shares can help earn income that will exceed dividends.
Another point in favour of option trading is that increase in share value will result in higher return on the call option purchase in percentage as compared to return on purchase of the underlying. On the other hand, you can profit from price falling in a similar way buying a put option. Option trading requires smaller investments than stock trading, however, it does not lower the risk.
Going into option trading is also a good way to protect the value of shares you own from potential decline. Having purchased a put option, you ensure the sale of your shares at the price, which is not less than the one you've determined to be the strike price.
| Three major features when trading in options |
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Leverage
To trade in the same amount of equity in the option market as opposed to the equities market, the option investor need only lay out a small percentage of the capital required. To be able to apply leverage within the options market is especially useful when speculating trading in the short term.
Protection
A particular benefit associated with stock option trading is being able to build insurance into any trading plan. In times when the market is unsure which way it is heading, protective put options can be bought to hedge a long stock position against a sharp drop in the underlying stock price.
Volatility Trading
An alternative to option trading on the upward or downward of the market, the options trader can speculate on whether or not there is any change in the underlying stock price. This is known as volatility trading.
What this all adds up to is that with some careful planning and research an options trader can benefit from investing in options, no matter which direction the market is going.
| Ways to trade in options |
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Stock option trading contracts are made between buyers and sellers, providing the former with rights to buy or sell the stocks, underlying the contracts at a fixed price. As options always are derived from the asset price, they are also called derivatives.
There are four different ways an investor can get into or out of the option market. He/she can buy call options or sell call options, alternatively, he/she can buy or sell put options. A person who buys is called a holder, and a person who sells is called a writer.
There are buyers of calls, sellers of calls, buyers of puts, and sellers of puts Buyers of calls are said to have a long position, while buyers of puts are said to have a short position.
If your strategy is to speculate, then calls are the way to go, where as if hedging is your preference, then puts are the answer. It all depends on the strike price of the underlying asset and on the expiration date.
In option trading you may choose between a great number of strategies, from conservative to high-risk, profiting from all-side market movements. In case you have solid reasons to believe that a stock price is going to grow, use the risky speculative strategy and watch the strike price to be exceeded until you choose to exercise the option of calling the block of stocks.
The reverse is true if you anticipate a decline in the asset price, you would then go into hedge. The latter strategy can also be used as insurance to protect one's investments and limit the losses, so you can sell your stocks before the option expires.
| Options Terminology |
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Now for those of you that have understood every word so far, I suggest you skip the next part, if however what has been written so far appears somewhat foggy, then read on.
Those people that deal in the Options market use a special language when talking about, dealing in and writing about it. Like most procedures, you need to understand the terminology used when dealing in options to get the full picture. Like a lot of words used in finance, once the initial meaning is understood, it is relatively easy to understand the underlying principal. Below, I have listed the more common terms associated with option trading.
Calls: A call is a contract giving you an option to purchase a block of stocks at a fixed price on or before a certain date. Now, it is important to remember that you are not obligated to make the purchase. You can exercise your option or not as the case may be.
Puts: A put is a contract to sell a block of stock at a fixed price on or before a certain date. Again, this is not obligatory. You can exercise your option or not as the case may be. As you can see, a put is the opposite of a call.
Holders: These are the buyers of the contracts, they are the people who are in a position to make the decision to buy or sell, in other words to exercise their options. Hence, it is the holders of contracts that christened the market with the name options.
Writers: As it takes two to tango, when trading on the options two parties are necessary. For every buyer there must be a seller, in other words, if someone is buying, than someone else must be selling. The writers are the sellers of the contracts. Be aware, that although writers do not have options, they are obliged to honor the contract if the holder decides to exercise his option.
Long Position: When trading in stocks, taking a long position means that you are holding the stock in anticipation of it increasing in value (you hope)
Short Position: Guess what, when you take a short position in stock trading, you are holding the stock in anticipation of it decreasing in value (again, you hope)
Underlying Asset: This is the actual stock or security that is the object of the option contract. The contract is said to derive its value from the intrinsic value of the underlying asset.
Strike price: The strike price is the price at which the option gives you the right to buy or sell. At any given time there are various strike prices available to trade on an underlying commodity.
Speculation: This is the risky side of trading, it is the risk associated with option trading as to whether you have got it right regarding the movement of share prices.
Hedging: This is the cautious side of trading. You think that the value of an underlying asset will drop below the strike price. It is called hedging because it is often used to protect an investment, or hedge your bet by maintaining an option to sell at a certain strike price should the underlying asset take a serious drop in value. In other words, you are able to bail out before your loss becomes too large.
Expiration date: This is the date on which your option must be exercised or it will be lost. It is the deadline. In the stock option market it is usually the third Friday of a month.
| What strategies are employed? | Top |
There are two types of options, puts and calls, these can be both shorted and longed as well as being used in both bearish and bullish markets, and the permutations associated with number of possible strategies that can be used with them are almost unlimited.
By involving yourself in the option trading market, you have the opportunity to profit from both upward and downward price movements associated with the stock market, you even have the chance to benefit from stock stagnancy!
The main types of strategies associated with option trading are bullish market strategies, bearish market strategies, neutral strategies and special strategies.
It is wise however, that before embarking on certain option trading strategies you make sure that you fully understand the reasoning behind the strategy: every option loses all of its time value in the end, every option expires worthless, and – more than a half of market activity fall to sideway movements.
The strongest position in bullish option trading is call buying. It limits the losses only to the premium paid, and is used in situations where there are undervalued options with growing volatility.
Put-selling is the opposite, it is a neutral option trading strategy suitable for use at bullish markets with high volatility. Profit made in the case of Put-selling is the premium obtained.
Other more bullish option trading strategies include purchasing vertical bull call spreads (that is, buying calls and selling calls of higher strike price) and selling vertical bear put spreads (selling puts and buying puts of lower strike price). The losses for the former are limited to debit and for the latter – to the spread between the strike price and the credit.
One of the strategies employed in a bearish market is put-buying implemented for undervalued options with volatility going up. Like the bullish option trading strategy, here you can only lose the premium.
If you consider the option to be overvalued and the market is either steady or getting bearish, it is feasible that you should adopt a neutral bearish position and sell a call. Remember that in this case profits are equal to the premium.
Other option trading strategies are vertical bear put spread buying and vertical bull call spread selling.
Option trading strategies for implementing in a neutral market include
• Strangle (using time value at maximum)
• Arbitrage (simultaneous purchasing and selling of similar options)
• Calendar (selling (buying) options in the near month and purchasing (selling) in the far month - basing on the assumption that near month time value falls faster
• Ratio Call (buying calls and selling calls of higher strike price)
• Guts (popular for the large premium)
• Butterfly
• Box
• Conversion (profitable for sure if adopted at credit)
You will need to do further research if you wish to find out more about strategies employed in options trading.
| And Finally | Top |
To become a successful option trader needs access to a great deal of resources of statistics and careful analysis of market behavior. It also requires one to react quickly to any changes that occur in the market, because in option trading it is possible to benefit from both up, down and side market movements.
Before you embark on your options voyage in somewhat choppy waters, it would pay you to have a few dry runs, i.e. paper trading. By researching the option trading subject and reading all the educational articles on offer, you should be able to get all the information required to begin option trading.
Find yourself a good broker, someone who can advise you on which particular option trading strategy to use in various situations. The broker you choose should also be able to offer practical advice regarding risks involved in option trading and help protect you from default on margin accounts.
Enter the option trading arena, only if you are confident and believe you know the right time and price to enter and to exit the market, make sure you understand the way to leverage on various market trends, and you have access to all the economic and company news applicable to your trades.
Good Luck and good hunting.
