Options TradingOptions trading canincrease the profits you make when trading Stocks if youunderstand 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 - OptionsTrading Basics, looks at what options are anddiscusses some of the options trading strategies traderscan 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 Stockor futures contract at a specified price up until a specified date. In other words, options arelike tradable insurance contracts. An investor can purchase a Put option as insurance against a decline in the Stock price or aCall option in case the Stock rises. Buying an optiongives the purchaser time to decide whether they will buyor sell the underlying Stock. The price is locked in untilthe expiry date, which in the case of LEAPS can be yearsinto 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 extraincome 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 lowerrisk - the most an option buyer can lose is the premium,or deposit, they paid on entering into the contract. By purchasing theunderlying Stock of Futures contract itself, a much largerloss is possible if the price moves against the buyersposition. An option is described by its symbol, whether it’s a put or a call, an expiration month and a strike price.
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.
The option contracts thatthey do
buy are usually only to hedge their physicalStock Portfolios
- that this is a powerfuldistinction between the punters and small
traders whoconsistently buy low priced, out of the money and close
toexpiry puts and calls, hoping for a bigpayoff (unlikely) and the
guys who really make the money outof the options market every month,
by consistently sellingthese options to them - please think about
this as youread the remainder of this article. Therefore, if he has sold CoveredCall options over his Shares, and the Stock price isabove the option strike price at expiry, the option is saidto be in-the-money, and the seller must sell his shares tothe option buyer at the strike price if he is exercised. Sometimes an in-the-moneyoption will not be exercised, but it is very rare. The optionseller (or writer) has to be prepared to sell the Stock atthe strike price if exercised. He can always buy back theoption prior to expiry if he chooses to and write one at ahigher strike price if the Stock price has rallied, but thisresults in a capital loss as he will usually have to paymore to buy the option back than the premium he receivedwhen he originally sold it. Many option writers simply get exercised out ofthe Stock and then immediatelyre-buy more of the same or another Stock and simply writemore call options against them. The buyer of an option has no obligationsat all - he either sells his option later at a profit or aloss, or exercises it if the Stock price is in-the-money atexpiry and he can make a profit. The vast majority ofoptions are held until expiry and simply decay in priceuntil 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, letslook at an example of how to use options to gain leverage toa Stock price movement when the trend does goin our favour... For this example we will useMSFT 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 willignore Brokerage costs, but they do have aneffect on the percentage returns. The prices and pricemoves of the Stock and the options are hypothetical - theyare intended as a guide only. Buying 1000physical 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 ourcapital. We will have $24,500
at risk if we take this position for a potential of12% or $3,000
profit. 10 contracts
represents1000 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
ofMSFT allows us to get the
full potential of the intrinsic value. $24.50(the
current price of the Stock) minus $22.50 ( the strike price) is$2.00,
which is our Intrinsic value. $2.80 (theoption premium)
minus $2.00 (the Intrinsic value) gives us$0.80, which is the
Time value. We will
have$2,800 at risk if we take this position, rather than thefull
price of the Stock ($24,500) for a potential of 80% or$2,200 profit,
plus whatever time value is left in theoption, probably another
$100. The option seller or writersimply has to sit back and wait until expiry to see if he isgoing to be exercised. If the Stock price is below thestrike price at expiry, he keeps the premium and can writeanother option over the same Stock. If the Stock price is abovethe strike
price, he will most likely be exercised andwill have to sell hisShares
if he doesn't exit the position by buying his optionsback on the
open market (quite often at a higher price than heoriginally sold
them for). 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. 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 tradersadvise never to hold an option with less than 30 days toexpiry due to the exponential rise in time decay duringthis period. For sellers, it is usuallymost profitable
towrite options that have 30 days or less to expiry,due to
this same time decay effect...the buyer of theseoptions has the
odds stacked against them and will require alarge price movement
in his desired direction to make aprofit -
remember, the vastmajority of options expire
worthless - so this is the sideof these instruments the wealthy
usually find themselves on- just a thought... For a more in-depth look atthe various Options strategies available, visit Optionvueresearch.com. This page has a series of articles on options trading andoutlines some of the strategies traders can use to profit from theseextremely flexible vehicles. We encourage you to studythese instruments carefully if you decide to trade them.Then use the trend trading strategies outlined inthese stories and articles to position yourself on the right side of themarket - whether as a buyer or a seller. We wish you well in yourtrading, Regards, The StockTrading Review Team
Copyright Stock Trading Review.com 2003-2007 |