The Power Stocks

Posts Tagged ‘Options’

Beyond all the ‘hype’ what is it that makes option trading so good?

This is a question that I wish more people would ask, but the thing is not too many people know they even exist!

The main reason that I love option trading is that options provide the opportunity to turn a small or modest amount of money into a large amount of money quickly!

How is this possible you might ask?

Well before I get into the ‘how’ that let me show you exactly ‘what’ options are.

Options are simply ‘contracts’ that give the buyer the right or choice (but not the obligation) to buy or sell shares in a particular company, at an agreed price, on or before a set date.

Now the thing is, as an option trader I am not interested in buying or selling stocks, I am only interested in buying and selling the options on stocks.

I want to buy an option for one price and then onsell it to someone else for a higher price and make a profit before the option expires.

Now whether or not I am able to do this depends on two main things:

1) Whether the underlying stock (the stock that the option is concerned with) goes UP or DOWN in price.

and

2) The type of option that I have bought.

Now, there are 2 types of options, CALLS and PUTS.

Call options give us the right to BUY shares in the underlying stock.

PUT options give us the right to SELL shares in the underlying stock.

As I said before, we are not interested in buying or selling the underlying stock, only in making a profit by buying the options (on a stock) and then onselling those options to someone else for a profit.

However, the only way we can make a profit is if the option itself increases in value.

So What makes options go up or down in price?

CALL options increase in value when the underlying stock goes UP.

PUT options increase in value when the underlying stock goes DOWN.

This may sound confusing if you are new to option trading, but basically what we want to do is to buy CALL options on a stock when we think it is about to go UP in price or buy PUT options if we think the stock is about to go DOWN in price.

If we are right and the stock moves in our desired direction, UP for CALLS or DOWN for PUTS, we will make money.

The concept is really quite simple once you accept that it is possible to make money whether the underlying stock moves UP or DOWN.

Now here’s the thing that makes option trading so appealing.

Options only cost a fraction of what it would cost to buy the underlying stock itself and a small move in the price of the underlying stock, creates a much larger move in the price of the option by 10 times to sometimes 100 times!

Let me give you an example, let’s say that GE is trading at $31.00 per share. If we wanted to buy 1000 shares in GE today it would cost us $31,000.

However, the option to BUY GE (CALL options) for $30 at any time during the next 60 days is only $2.00 per share. If we bought enough options to give us control over 1000 shares in GE it would only cost us $1,500.

Now let’s say that GE goes up by $1.00 to $32.00 during the next 3 weeks.

If we had bought the shares in GE we would have have made a $1,000 profit (1000 shares x $1.00 per share) or 3%+ return and if we bought the options on GE we still would have only made $1,000 (1000 shares x $1 per share) however as we would have only invested $2,000 into the trade, this would be a return of 50%!

By trading the options instead of the stock it is possible to make far greater returns and at the same time risk only a fraction of the capital.

This is called LEVERAGE and this is the main advantage to option trading over other wealth creation strategies.

However, just as leverage can work for you it can just easily work against you.

This is why you need a solid trading system that stacks the odds of success in your favor on every trade and at the same time reduces your risk.

Options trading is an investment vehicle for experienced investors, who track their investments proactively. It is not a suitable vehicle for investors looking to maintain assets without direct management, as it’s very much a timing related purchase and float. Options trading is an excellent technique for using financial leverage to make bigger purchases.

A very simple example of an options trade would be this: If you’re selling a commodity worth $100,000 (say 1,000 shares of a stock worth $100 per share), and a prospective buyer likes the price, they can offer to pay for an option to buy all of those commodities, while spending the time researching other investments. Say, for example, they’re offering you $1,000 to hold that price for them while they gather the rest of the funds, which they say will take three months.

When three months passes, they either pay the remaining $99,000 for the shares of the stock, or forfeit the option. If the stock goes up in price to $110 per share from $100, they can either buy the stock, or sell the option to someone else for the difference between the old price and the new price. Either way, the person holding the option stands to make a tidy profit.

Options trading has its own set of terminology, which we’ll get into a bit later, but the basic premise is this: You buy an option to purchase a stock or commodity at a given price; the option expires after a given time period (American style options trading), or the option must be exercised on a specific date (European style options trading).

There are two principle types of options that are traded. Calls increase in value as the stock price rises, and puts increase in value as the stock price declines. (There’s a lot of fiscal mathematics behind both of these, but the layman’s explanation will suffice.) In most cases, options are sold to other investors just before they expire; most options traders don’t end up holding shares in the stock they have options for; the options are bought, sold, liquidated and transacted before their expiration dates. It is possible to have both call and put options on the same commodity or stock; this is a “straddle” strategy.

Options trading is not a casual investment strategy; it’s a strategy used by people who are investing as their profession, or who intend to manage their own wealth directly. The benefits of options trading is flexibility, coupled with (in the case of put options) a bit of a countercyclical strategy for bear markets.

The key to options trading is market research on specific stocks; an options trader will be researching stocks that are either slated for a price spike (call options) or are likely to undergo a price decline (put options). How quickly these options express themselves is a measure of market volatility, and most options traders will try to take a neutral position – they’ll put in put and call options to cover both directions, and to cover themselves against broad market trends.

Options arbitrage is a lower risk strategy done by floor traders, and can be short term profitable, with good liquidity. The aim is to swap options with other traders before certain factors influence the market, or to get rid of underperforming options while still getting some profit out of them. Options arbitrage is perhaps the best place to start in options trading for a novice.