Learning about trading options will allow you to add a whole new dimension to the way you trade the financial markets. Although it will take some time to learn how to trade options with confidence, the payoff can be potentially enormous.
Options can be traded for pure speculation or they can be traded to safely hedge against trading risk by acting as financial insurance. They can also be traded for anything else that lies in between this wide spectrum once you learn how to properly construct the vast array of high-profit, low-risk option trading strategies.
Option strategies can be created to be within any affordable price budget or even created to earn a certain profit outcome all with limiting your financial risk. You can also create option strategies that will cost you virtually nothing to trade or ones that will even pay you up front with cash deposited directly into your trading brokerage account!
On the more speculative side of trading options they can really turbo-charge your trading profits with returns like 100%, 300%…500% (or even more).
Three Ways To Profit From Trading Options
- From the underlying financial instrument rising in price
- From the underlying financial instrument falling in price
- From the underlying financial instrument moving sideways in price
Two Types Of Options
- Call Options: Buying a call option gives you the right, but not the obligation, to buy a certain amount of shares of a company’s stock at the call options strike price on or before the options expiration date. If you think that the price of the underlying financial instrument will rise you would buy a call option to make a profit.
- Put Options: Buying a put option gives you the right, but not the obligation, to sell a certain amount of shares of a company’s stock at the put options strike price on or before the options expiration date. If you think that the price of the underlying financial instrument will fall you would buy a put option to make a profit. (To learn more about put options, click on How Does A Put Options Work).
Option Expiration Dates
- Generally, you can buy and sell options that have expiration dates as short as a day to several years away, which are known as Long-term Equity AnticiPation Securities (LEAP’s).
Option Strike Prices
- Options can come with many different strike prices. For example, the strike price of a call option on a stock is the amount that you could actually buy the stock for regardless of the stock’s current price. So, if you own a call option with a strike price of $30 and the current price of the stock is now $38, you have the right to buy the stock for $30. Or, you could forgo buying the stock altogether and instead just sell the call option outright (on or before the option expiration date) to collect the profits. Depending upon the relationship between the current stock price and the related options strike price, options can be: in-the-money (I-T-M), at-the-money (A-T-M), or out-of-the-money (O-T-M).
Option Equivalency
- Options are expressed in units of 100. So, buying 1 call option (or put option) would be equivalent to controlling 100 shares of a stock (buying 5 call or put options would be equivalent to controlling 500 shares of a stock, etc.).
Alluring Attractions To Trading Options
- You can control the same number of shares of a stock for just a small fraction of what the stock would otherwise cost to own it (to learn more see Lease Stocks for Just a Small Fraction of the Actual Stocks Price)
- Risk is limited to the amount paid for the option premium
- Opportunity cost – instead of buying just one stock requiring a much larger cash outlay, you could instead take the capital and employ it into say 10 different option positions
- You can be wrong more than you are right and still make money trading options
Example: you have $2,000 to spend and bought 10 equal option positions. You were completely wrong on 6 out of the 10 option positions, resulting in losing 100% of your money on those options. However, with the remaining 4 option positions they gained anywhere from 75% to 225%, resulting in erasing all those earlier sustained losses and now producing an overall profit. So, even though the majority of your option positions resulted in losses, you were still profitable!
- A small favorable movement in the price of the underlying stock will produce a magnified gain in the price of the option
Example: to double your money on a $30 stock, the stock would have to go to $60. However, with choosing an at-the-money call option with say six months to expiration, the option could have very easily doubled in price once the stock reached say approximately $35.
- Very flexible as to creating all kinds of low-risk, highly-profitable option trading strategies
- Trade rising, falling or sideways financial markets
- Can be used to hedge against trading and portfolio risk
Risks Of Trading Options
- Time decay (more rapid in the last 30 days). However, time decay can work in your favor if you are “short” rather than “long” the options
- Not buying enough time on the option to cover the time horizon expected for the anticipated price movement of the underlying stock
- A small unfavorable movement in the price of the underlying stock will produce a magnified loss in the price of the option
- Buying too may inexpensive out-of-the-money options
- The bid-ask price “spread” is too wide
- Low volume and low open interest
- Collapse in implied volatility after buying options
- Allocating too much of your trading capital to options trading
Key Aspects To Understanding Options
To fully understand the dynamics of how options really work you should gain a solid understanding about the following key aspects:
- Option Chains
- Time Decay
- Implied (and Historical) Volatility
- Volatility Skews
- Volatility Charts
- Volume and Open Interest
- Exercise versus Assignment
- Intrinsic Value and Extrinsic Value
- Strike Prices and Expiration Dates (see above)
- The Option Greeks (delta, gamma, theta, vega and rho)
- Options that are (I-T-M), (A-T-M) and (O-T-M)
- Analyzing Option Strategies
Options Exchanges & Options Clearing
- Options are traded on various regulated options exchanges. The world’s biggest options exchange and maker of listed options is the Chicago Board Options Exchange (CBOE) which was founded in 1973. The CBOE was the first option exchange to trade listed options where today most of them are now traded electronically. The CBOE’s options contracts are cleared by the Options Clearing Corporation (OCC).
- The Options Clearing Corporation (OCC) is the world’s biggest clearing house that clears financial transactions such as options and futures where they guarantee the fulfillment of obligations between buyers and sellers. The OCC functions under the authority of both the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
To learn more about options get your free PDF download Characteristics and Risks of Standardized Options and Supplements produced by the Options Clearing Corporation.
Last Thoughts About Learning How To Trade Options
Take the time necessary to invest in yourself and learn how to trade options intelligently and profitably. Learn all about the related risks and rewards of trading options as well as the powerful strategies that you can easily create which will add a whole new dimension to your trading arsenal.
