Many investors in the stock market regard stock options trading as a high-risk form of speculation that is equivalent to rolling the dice at a gambling casino and for that reason spend no time learning about them. That is understandable, many experts advise against them and the general belief is that 90 percent of those who do venture into trading options lose money.
But it would be worthwhile for the investor who has learned how to survive and make money in the stock market by trading stocks to look a little closer into trading options. When successful, an options trade can provide several times the amount of financial gain compared with the amount gained from an equivalent stock purchase in the same company.
In addition to trading options for speculation, options have a major use in hedging, a form of insurance to reduce exposure to the risk inherent in financial matters. Options are widely used by portfolio managers, banks, corporations and corporations for that reason, often using complex strategies beyond the scope of this article to discuss.
Advantages of buying Call and Put options
Let us look at the possibilities offered by trading options using the simplest strategy of buying calls or puts. Options are traded in the form of contracts, each contract being an option on 100 shares of a specified stock, usually referred to as the underlying stock. There are two types of options, known as Calls and Puts.
Less capital, limited loss
The amount of working capital required in trading options is far less than in buying stocks, the maximum loss is fixed to the amount paid for the option and the potential gain is limited only to how far the underlying stock moves within the time remaining in the term of the option.
Leverage
The advantages of owning the option is the leverage provided by controlling blocks of 100 shares of stock at a fraction of the cost of the actual stock and being able to share in the activity of the stock as it fluctuates in the marketplace.
Definitions of Call and Put
A call stock option gives the holder the right to buy a specified stock at a specific price for a period of time until a specified expiry date.
A put stock option gives the holder the right to buy a specified stock at a specific price for a period of time until a specified expiry date.
The specified price is called the Strike Price or the Exercise Price.
Strike Price and Expiry Date
Options are listed on the various stock exchanges and are available at varying strike prices above and below the price at which a stock is currently trading, referred to as the Market Price or Spot Price. Options are also available with several different months of expiry according to a pre-established calendar.
The option price will vary in relation to both its strike price and the amount of time remaining until expiry, and of course, the option price, the bid and asked, will reflect the changing value of the underlying stock.
The importance of time
An option is described as a wasting asset because it loses part of its value each day towards the final day of expiration when it becomes worthless and no longer exists. The importance of this is that if the underlying stock does not perform as expected within the given time, even if it does at some later date, it is too late and the position will have produced a loss.
The consequence of this is that at any given time, the closer the expiry date of a stock option, the less will be its value and conversely, the farther away, the more value it will retain.
The importance of strike price
In much the same way that value changes with time, the value of an option is related to its strike price compared with the current market price of the underlying stock. For instance, in the case of a call option, if the strike price is lower than the stock’s price it will be worth more than if the strike price was the same as the stock, and a strike price higher than the stock price will be worth even less compared to the other two possibilities.
A call strike price lower than the market price of the stock is referred to as being “in the money”, if it’s the same as the stock price it is called “at the money” and if it is higher than the stock price it is called “out of the money”
Trading Options, in conclusion
The success in trading options depends on the ability to choose stocks that move up in price in the case for Calls and down in price for the case of Puts, and stocks that do so within the time before the option expires.
For the beginner, trade the simpler calls and puts, and choose the strike prices and expiry date that carry the lowest risk. That means buy options with a strike price at the money or in the money, the out of the money strikes have the highest risk, and for expiry dates do not choose dates that are near to the time of purchase, the farther out has less risk because it allows more time for the anticipated price move of the chosen stock to occur.
And lastly, sell the option no later than one month before the expiration date. If you have a winner that is still gaining, it can be “rolled up” to be replaced with a farther out expiry date.
In a winning stock trade, those last recommendations being less risky will provide a good profit but a lesser return than in trading options using higher risk strategies, but for the beginner the way to learn is to take the safer route.
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