 |
Understanding Options and How to Trade Them
Author: Richard Cochrane  | Posted: 22-03-2007 | Comments: 0 | Views: 26 | Rating: (52)  (?) 
In this article I want to describe the basics of options: what they are and how one can trade them.
Options trading is extremely popular and provides far greater possible returns than does trading in the underlying stocks. But it also carries more risk.
So it is extremely important to understand how options work as financial instruments and be clear on what your potential risk and rewards are in trading them.
Options are contracts on some underlying trading instrument - shares of stock, bonds, a commodity, even a mortgage loan! Stock options are the ones most people are familiar with and are the most traded by individual investors.
But regardless of what the option is on, there are common features. One of the most basic is the contract feature specifying what the option owner has actually contracted for.
There are two types of Option Contracts: CALLs and PUTs.
CALLs
A 'call' confers on the (option) contract holder the right to buy an asset at a stated price on or before a specified expiration date. An option to buy, but not an obligation. That's why it's called an option!
The owner also has the option to let his contract expire. But then he loses everything he invested in buying that contract.
Essentially, when buying a Call option, you are betting that the underlying asset will increase in price before the expiration date. And, not only rise, but rise enough to make a profit.
But whether you make a profit is determined by the price you paid for the option, and the increase in price of the underlying asset. Clearly the price must rise enough to cover the difference between the market price and the price at which you can buy the security (the strike price of the option contract). And, since the option itself has a cost, the price has to rise enough to cover that additional amount. That cost is called 'the premium'.
The cost of the option fluctuates with the supply and demand for that contract on the open market. Several factors determine the premium, including the price of the underlying asset, the strike price of the option, the time remaining on the option, and others.
The time remaining is particularly important. Naturally as the option contract nears its expiry date the price of the underlying asset (the stock for example) is less likely to change dramatically from its current price. Therefore the result of excersizing the option is known with more certainty and the cost of the option reflects that outcome. For example, if a Call option is nearing its expiry date and the value of the underlying asset is lower than the strike price of the option the option is practically worthless, and so its cost will be very low.
Suppose it's June 1, for example, and Intel (INTC) has a market price of $27. Call options for Sept 30 are selling for $3 with a strike price of $30. You buy one contract for 100 shares.
So, if you held until expiration you either lose $300 ($3 x 100, the initial price of the contract not including commission), or buy the underlying stock at $30. If the current market price were $35 you've made $200. ($35 - ($30+$3) = $2 per share x 100 shares, ignoring commissions.)
When the market price of a share is above the strike price, the option holder is 'in the money'. If the market price is lower, he's 'out of the money'.
PUTs
A 'put', by contrast, gives the option buyer the option to sell an asset at a certain price by a stated date. The option, not the obligation.
Puts are similar to 'shorting stock', in this sense. Put buyers are betting the stock price will fall before the option expires. In this case the market price must fall below the strike price in order to garner a profit from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those circumstances, the option holder is 'in the money'.
For example, take the same situation as above but let the option be a put. If the market price falls to, say $25, your profit would be:
First, $3 x 100 = $300 = Cost of put, excluding commissions.
Then, buy 100 shares at $25 per share = $2,500 to repay broker 'loan' (since shorting stock involves borrowing shares you don't own, then repaying later).
Finally, sell 100 shares at Strike price = $30, 100 x $30 = $3,000
Therefore, your profit = ($3000 - $2500) - ($300) = $200.
(Actually, the broker takes care of all the underlying mechanics. The investor merely orders the trades at a given time and date.)
Whether investing in calls or puts, wise investors do need to do their needed homework. Options trading is risky and somewhat more complicated than simple stock trading.
But it can be extremely lucrative!
Rate this Article:
Current: 0 / 5 stars - 0 vote(s).
Article Source: http://www.articlesbase.com/finance-articles/understanding-options-and-how-to-trade-them-120812.html
|
Submitting articles has become one of the most popular means of generating quality backlinks and targeted traffic to your website. Join us today - It's Free! |
|
Related Articles
Options Trading - Benefits of Leverage
By: Richard Cochrane | 21/03/2007 | Finance
Options are frequently overlooked by traders because they seem complex or are not readily understood. Learn about how options can be traded and how leverage can help you make tremendous returns
Options Trading 101
By: Richard Cochrane | 22/03/2007 | Finance
Options can be a valuable addition to your investment portfolio. But they are often misunderstood, or thought of as too complex or risky.
This article begins to clarify what options are and how to trade them
How to Profit from a Market Correction: Diversified Trading Strategies
By: Richard Cochrane | 03/04/2007 | Non-Fiction
What happened to the stock markets in early March?
Many investors, especially long term investors made big losses.
And they're probably asking:
"Is there some way I could have avoided making losses during that period?"
Well, the answer is absolutely Yes.
A Day in the Life of a Trader
By: anna coulling | 25/02/2007 | Investing
As a full time trader I spend my day analysing and interpreting the markets. The article provides an introduction to a typical day, and the information you would need to assess, in order to identify trading opportunities in the markets.
Historical Stock Splits Confound the Greatest of Wits
By: Adam Hefner | 28/05/2008 | Day Trading
There are many terms thrown about when discussing all things trading. It can often prove quite confusing. From candlesticks to stochastics, the terminology is endless. So what refers to a stock being cut in half, but not in a bad way?
Buy to Cover Orders with Stock Trading
By: Pat Jackson | 24/12/2007 | Investing
When you buy to cover on a market order, you are in agreement that you will purchase the stock at the current market price, however, because there is a lag between the time you agree to purchase the stock and the actual transaction, a price difference could occur. You could end up paying more than anticipated for each stock, or a considerably lower amount per stock, which is what you are hoping for.
Common Scams Directed At Consumer Investors
By: Pat Jackson | 03/01/2008 | Investing
With the advent of online brokers, many individuals are placing themselves in the driver's seat for purchasing stocks and bonds. The process requires a lot of research and little luck. A quick search online can bring an individual investor all the information they need in order to make those decisions.
Online Stock Trading - Stock Trading Strategies
By: Amar Mahallati | 26/06/2007 | Finance
The ease of online stock trading draws the attention of new investors and investors looking for an alternative to the old methods of trading. With little more than an account and a mouse fortunes can be made or lost from the privacy of one's own home. However, before getting carried...
Got a Question? Ask.
Ask the community a question about this article:
Frequently Asked Questions
What was dick cheny's Haliburton/kbr stock worth ...
By: figpop | 01-07-2008
what was dick cheny's Haliburton/kbr stock worth in 2001
Technical Analysis (Weekly SMA onto a Daily chart)
By: KoolKat | 30-06-2008
On a stock chart, how would I place the Weekly Simple Moving Average line plot on to a daily price chart (and Vice Versa)?
Please help, i'm really getting scared now
By: Mary Kaucher | 29-06-2008
we had a new garage door put it make noise, then my cat 5yr old around 3am that night/early morn he came into my room and number 2 ed on my a pile of my cloths, that being the first time he didn't use the box. it was runny, with a little blood, and i know he went outside the box plus the above discrip of the #2, meant he wasn't feeling good. so i kept in my room to what over him until daylight so i could take him to the vet. about 7 am (4 hours later) he ran out i hid somewhere in the house. its i've been looking everywhere, its now 4:45am (going on 24 hour ago) i he has not come out of hiding, i still can find him. i'm getting real scared... next i empty the house, before i fear the worst, that he got out and is lost for every. Can you give me some help on hiding place, and time frames of concern. ie longest times cats have been known to come what out of hiding, ticks to get them out, what should my main concerns be.. please help
Family Search
By: Vicki Smotherman Golden | 28-06-2008
Family SearchJohn William Cullom Smotherman married Queenie Fredericka Overstreet in the 1800's in TennesseeQueenies parents may have been John and Margerite OversteetA sister Molly Overstreet
Want to trade meds?
By: emokitty134 | 27-06-2008
Hey I get 0.5 clonpins and they are just not doing it for me, Anyone whant to trade me a low dose of xanax or valume. I live in philly and my AIM is psychokitty186 so contact me if you want to trade.
Securites reporting
By: bob sandler | 26-06-2008
what companies have filed a 14c report with the stae of nevada sine june16,2008?
Q&A Powered by: 
Latest Finance Articles
Things To Do When Making Your Timeshares For Sale
By: Stephen Campbell | 19/07/2008
Selling of your vacation property is better known as timeshare resale. In selling your timeshares, there are lots of consideration that you must take to effectively do it.
Life Insurance Without Invading Your Privacy
By: Marilyn Katz | 19/07/2008
Protect your privacy, and save time with simple issue, no medical exam term life insurance policies.
Does My College Student Need Renter's Insurance?
By: Jim Waltrip | 19/07/2008
Find out the best way to protect your college-aged child's possessions while he is away at school. Are your college student's belongings covered by your homeowners insurance, or should you consider purchasing renter's insurance?
A Primer on Applying For Student Grants
By: Ron Subs | 18/07/2008
Student grants are one of the best financial resources available but some grants are left untouched at the end of the year due to few people applying for them.
Tips About Cash Advance For Everybody
By: Stephen Campbell | 18/07/2008
A lot of people opt for cash advance because they cannot afford to wait for payday. Thankfully, cash advance works for nearly everyone to get the cash they need until payday.
Using Automated Investment Strategies To Invest Wisely
By: Jim Pretin | 18/07/2008
If you are a novice investor and you can not decide when it is the right time to buy or cell a certain stock, talk to your broker about automated investment strategies like DCA and DVA
Good News For Income Investors
By: Steve Selengut | 18/07/2008
Admittedly, even if your asset allocation has been fine tuned for years, lower portfolio market values in this area make stock market valuation shrinkage feel even worse. But the value of stable cash flow becomes painfully clear for investors who misguidedly depend on capital gains for their spending money.
How Do You Magnetically Attract People To You
By: Jackie Khor | 18/07/2008
Would you like to become wealthy working from home, pay off your debts, spend more time with your family, and retire in style? Would you like to have a multi-million dollar investment portfolio, live a life of abundance and eventually leave a rich legacy for your children?
More from Richard Cochrane
The Art of Hedging in Options Trading
By: Richard Cochrane | 15/08/2007 | Finance
There are many different ways to use hedging as an effective trading strategy. Especially with options where their time characteristics and leverage can be used to make great gains!
How to Profit from a Market Correction: Diversified Trading Strategies
By: Richard Cochrane | 03/04/2007 | Non-Fiction
What happened to the stock markets in early March?
Many investors, especially long term investors made big losses.
And they're probably asking:
"Is there some way I could have avoided making losses during that period?"
Well, the answer is absolutely Yes.
Options Trading 101
By: Richard Cochrane | 22/03/2007 | Finance
Options can be a valuable addition to your investment portfolio. But they are often misunderstood, or thought of as too complex or risky.
This article begins to clarify what options are and how to trade them
Options Trading - Benefits of Leverage
By: Richard Cochrane | 21/03/2007 | Finance
Options are frequently overlooked by traders because they seem complex or are not readily understood. Learn about how options can be traded and how leverage can help you make tremendous returns
|
|
Finance 
