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  • All You Need To Know About Options Trading

    ***This article was originally posted to DayTraders.com. It was the largest website on the internet for traders from 1996 to 2008.








    WARNING: Extremely risky is the phrase that would best describe Options Trading! Losses of up to 100% of your trading capital invested in options is by no means a rare event when using and/or actively trading stock and other types of options. In some cases, it is possible to lose bigger than you have invested by writing uncovered call and/or put options. Please be extremely careful should you decide to trade and/or invest in options of any kind.



    Below is a concise overview of options: what they are and how they function.



    · INFORMATION ABOUT OPTIONS ·



    WHAT IS A STOCK OPTION - A stock option is a contract that gives you the right, but not the obligation, to buy or sell an underlying stock at a specific price (called the strike price) during a specific period of time as outlined by the contract. For this right, you pay the writer of the option contract a premium based on the option purchased.


    The price of an options contract is based on a number of factors, including volatility of the underlying stock, time left in the contract and other factors such as the difference in price between the underlying stock and the price at which the contract allows you to purchase or sell the stock. This valuation can be dynamically calculated using a mathematical model called the Black-Scholes Option Pricing Model.




    TYPES OF OPTIONS - There are two types of option contracts: call options, which give you the right to buy a stock and put options, which give you the right to sell a stock. Just remember the following:
    You call a stock to yourself when you buy
    You put a stock toward someone else when you sell









    A call option would be purchased when you expected the price of the underlying stock might rise, while a put option would be purchased if you expected the price of the stock to decline.


    If you are correct in your assumption, as the underlying stock changes in relation to the strike price of the option(s), it creates what is called “intrinsic” value in the contract. For example, if you have a contract to buy 100 shares of stock at a fixed price of $50 and the price of the stock suddenly moves to $65 a share - the value of the contract would be the difference in price between the stock and the strike price (in this example $15) plus the time value remaining, multiplied by the number of shares the contract allows you to purchase at this fixed (and more favorable) price.


    As mentioned above, the strike price is the price specified in the options agreement or contract which outlines at what price you can purchase or sell the underlying stock. When the price of the underlying stock is near or equal to the strike price listed in the options contract, the contract is said to be “at the money”. However, if the price in the options contract allows you to purchase or sell a stock at a favorable gain, then the contract is said to be “in the money”. For example, in order for a call option to be “in the money”, the price of the actual stock would have to be greater than the price the option allows you to buy it at.


    A stock option is said to be “out of the money”, when the price of the stock is in an unfavorable relationship to the strike price of the option. For example, on a put option (which gives you the right to sell a stock at a fixed price) the stock price would have to be higher than the price listed on the options contract in order for the put option to “out of the money”.




    THE LEVERAGE POWER OF OPTIONS - One of the most attractive aspects of options (as well as one of the most dangerous) is that they can provide you with the ability to greatly leverage your money. This is because with an options contract, you can - in effect - control a fairly large amount of stock with a relatively small amount of capital (at least when compared to the cost involved with buying the stock outright). The problem (or risk) is not so much this leverage, but when this leverage is abused.


    In fact, when used correctly, options can actually reduce risk. Options can allow you to control a desired number of shares of stock for a specific time period with a fixed and completely limited “down side” (i.e. the price of the options). Trouble arises when investors buy beyond their means and/or subject all their capital to the risks associated with options. Namely, the risks associated with their volatility based on the movement of the underlying issue, as well as the loss of value as the contract begins to expire. Keep in mind, sometimes as little as a one or two point move against you in a stock’s price will drop the value of an options contract (at least one that is at the money) as much as 50 to 75 percent in some cases (this is especially true of options with little time value remaining).


    With respect to the actual leverage provided, this ratio can be calculated by dividing the strike price of the contract by the actual cost of the contract. Typically, when dealing with stock options the leverage provided can be as high as to 10 to 1 as compared to buying the stock itself.


    Consider the following example: You purchase a call option on XYZ stock. XYZ stock is currently trading at $40 a share. Let’s assume a one month call option on this stock with a strike price of $40 is selling at $4 per option.


    Options are sold by number of contracts. A contact by definition is a group of 100 options. As such, “one contract” would be $4 multiplied by the number of options in the contract (100) for a price of $400. This would give you the right to purchase 100 shares of XYZ stock at a fixed strike price of $40 for the next month regardless of what price the stock might move to.


    Now let’s look at how the option price moves in relation to the stock. Assuming the stock did not move, the option would slowly deteriorate in price until it was worthless after one month.


    However, if the stock were to move to $44 a share before the option began to significantly deteriorate with regard to remaining time value, we could see the option value move up to $8 per contract. Only a 10% move in the stock price itself, however a 100% move in the options contract value. At this point, assuming the options were selling for roughly $8 each, your contract would now be worth approximately $800 (note that this example does not take into account market prices nor specific time valuations).


    In fact, on the subject of specific time valuations, let’s keep in mind that if the stock did not move up to $44 a share until the last day of the option contract, there is a very good chance that the option would drop by $4 due to expiration of time, while at the same time increasing by $4 due to the move in the stock - thus the drop in time value and the increase in intrinsic value would cancel each other out - leaving the option valued at $4 each.


    Finally, let’s consider the case where the stock fell to $35 a share. Certainly, holding a contract that allowed you to purchase the stock at $40 a share, while at the same time the stock was selling in the open market at $35 a share would not be a very valuable situation. This would leave the contract with only time value left, which would most likely not offset the drastic “out of the money” condition. However, if during the one month period, the stock returned to $40 or greater, value would subsequently return in the options and the contract as well.




    THE OPTION WRITER - When you purchase an option on a stock, you are actually purchasing it from another individual and/or firm on Wall Street that is writing the actual options contract. If you stop and think about it, this is a somewhat startling fact, since it means someone is actually betting directly against you being correct in your assumption of profitability on the final outcome of the option. While it’s true option writers may hedge themselves to limit and/or reduce risks, at the same time, the basic idea is that you are taking up a position against someone who is pricing the option in an effort to ensure you will not take his or her money. When trading options, you need to always keep this point in mind.


    Also understand that while options are traded in a market very similar to stocks, there is much more latitude as far as how pricing can work between buyer and seller. The bottom line is that if someone is silly enough to overpay for an options contract, there will most likely be someone willing to write that contract and sell it. If you really want to see a first-hand demonstration of this, just place a market order for an option contract sometime. Look out!


    Additionally, spreads between the price which you must pay to open the position and the price available to you should you decide to close the position, can be extremely high from a percentage standpoint of view. When taking up or selling option positions, a good rule of thumb is to only use limit orders - unless you absolutely need in or out of a position and are willing to be exposed to a possible big hit by the markets in the process.




    CLOSING YOUR OPTION POSITION - Selling options is basically very straightforward. Assuming there is value left in your position and/or it in the money, you have one of two choices. You can either sell the option to someone else and reap the profit, or you can exercise the option and take over the stock.


    Note that in some cases (generally with very large option positions) you may not have the cash available in your account to “buy” the stock of the underlying position. In this case you would typically sell the contract without exercising it, however, if you run into a situation where there are no buyers and/or the market does not appear to be favorable for selling the contracts, you can, in fact, direct your broker to exercise the options and then simultaneously flatten the position by selling the stock at the market. This should not generate a margin or house call in your account since you have effectively bought and sold the stock at the same moment. Normally this is not required since options generally can be sold into the market.




    OPTIONS EXPIRATION - Options expire on the 3rd Friday of the month in which the option is written. For example, a January call option will expire on the 3rd Friday of January. Technically it expires on Saturday, but Friday is the last day you can trade it. Note that options which expire with a value of 3/4 of a dollar or more are automatically executed in your account. Those with a value less than $0.75 must be manually executed or they will expire worthless.


    Options are cleared through the OCC - the Options Clearing Corporation. Questions regarding the finer points of options can be found at their website or at the additional links listed at the end of this document. The OCC’s website is located at:




    OPTION TICKER SYMBOL FORMAT - Options trade under ticker symbols, much like stocks do. However, they use a somewhat strange notation system which at first glance is a bit confusion to the novice.


    Typically a stock option will have an “options root” associated with it which identifies the underlying stock. NYSE listed stocks often use the original ticker symbol, while Nasdaq listed stocks use a root which is partially derived from the name in most (but not all) cases.


    A list of option roots for most stocks can be found at the Chicago Board of Options Exchange website


    Finally, a two-letter suffix is added to the end of the root to denote the month of the option and whether it is a call or put, plus the strike price (respectively).

    As an example, an IBM November $150 call would be: IBM KJ.
    A Microsoft January $70 put would be: MSQ MN

    ADDITIONAL RESOURCES FOR OPTIONS - Following are links to websites that can provide additional information regarding options. In addition to visiting these sites, we would strongly recommend reading the book Keys to investing in options and futures by Nicholas G. Apostolou & Barbara Apostolou.


    Options Books:

    Trading Options For Dummies

    Understanding Options

    Covered Calls Made Easy
    Platinum Swing Trade Alerts (FREE 14-Day Trial)

    Best Stock Picking Services


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  • #2
    Thanks for the information.

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    • #3
      I'm thinking about starting more options trading soon. Any tips?

      Comment


      • #4
        Great article. I've been reading up on options all weekend. I like the fact that you can control a large amount of stock without needed to purchase the cash shares. Definitelty interested.

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