Options trading can be a highly profitable investment – PROVIDED you have a sound strategy.
Many people are dazzled by the unlimited earning potential of options – their approach to trading is extremely haphazard and comparable to gambling. If you try to trade options without proper knowledge and a proven strategy, say goodbye to your money – because you will never see it again!
However, if you take the time to learn the tricks of the trade, you will have a reliable source of income for life.
It might take some time to get there, but ultimately – you will have created a lifestyle where you will no longer be dependent upon your day job for income. You will work just a few hours per week (maybe even just a few minutes per day) and make more money than you ever thought possible. You will not have to struggle for money.
Instead of working hard like an employee, you will work smart (like a true investor). You will let your money work for you – not the other way round. This article is by no means – a comprehensive guide to options trading strategies. However, it does deal with some very important concepts. So stop watching pranks on YouTube and pay attention.
These are some of the common terms associated with options trading.
Strike Price: This is the price at which the underlying asset can be sold or bought. If you are a call holder, then the price of the asset should go above the strike price for you to make a profit. If you are a put holder, then the asset price should fall below the strike price. Of course, all this must happen before or on the expiration date.
Premium: This is the total price of an option. The premium is determined by a number of factors such as volatility, time remaining till expiration (time value), strike price and the price of the underlying asset itself. Calculating the premium of an option is a complicated procedure that is best left to the experts.
Listed Options: Options that are traded on any national exchange board are known as listed options. These have a fixed expiration periods and strike prices. Every listed option is known as a contract – a contract represents one hundred shares of a certain company stock.
A call option is said to be – in the money, if the price of shares is more than the strike price. A put option is – in the money – if the share price is lower than the strike price. The positive difference between the share price and the strike price is known as the intrinsic value of that particular option.
Speculation: Options are highly versatile and hence, they allow you to make money not only when the market goes up, but also when the market crashes! Still speculation is a risky affair. Not only do you have to predict whether a company stock will go up or down, but you also have to take into account factors such as the magnitude of the fall/rise in prices and the timeframe. So why do people speculate despite the odds being stacked against them? Well, a single contract represents 100 stocks and hence even if the share price goes up or down by just a little bit – it can lead to substantial profits!
Hedging: As an option holder, you are not obligated to buy or sell. You can simply let an option expire. This acts as a buffer and protects you from losses if the underlying asset performs badly (with respect to your position). If an option expires, you might lose the amount you spent to buy that particular option. However, as mentioned earlier – a single contract includes 100 shares and hence, it is much better to incur a small loss by letting the option expire than losing truckloads of money on a poorly performing asset.
Consider this example:
Imagine a firm named Jacks Beer Company. The stock price of the company is 77 dollars on the first of June. The premium is 3 dollars for an August 80 call. The contract states that the expiration date is 21 August. Hence, for a call holder to make a profit, the stock price must go above the strike price of 80 dollars before 21 Aug.
Note that a single contract contains 100 shares, hence, the initial investment amounts to the premium multiplied by 100 (3 x 100), which equals to three hundred.
4 weeks later, the price of a single share of Jacks Beer Company goes up to 85 dollars. The options contract too has gone up and is now priced at 8 bucks (8 x 100 = 800). The investor can sell the option and make a profit of 500 dollars (800 – 300 = 500). This action is known as closing ones position.
By the 21st august, the stock price has fallen to 75 dollars, which is below the strike price. Hence, the option is worthless and the investor loses the initial investment of 300 dollars.
As you saw in the above example – swift and decisive action is required to make profits in options trading. You can begin by practising with virtual money before moving on to real funds. There is no set formula which cracks the code for all options. You have to use a combination of common sense and expert knowledge in order to correctly speculate the movement of share price. For example: It is highly probable that the share prices of beer will increase during the summer and in football season.
An investor also has the choice of exercising an option – which means that he/she can buy the company stock when the price hits 80 and then sell it at 85 in order to make a profit. However, statistics indicate that only 10 percent of all options are ever exercised. Close to 60% are traded out (closed out) and the rest – about 30% expire since they become worthless.
There are two major types of options: American and European.
American options can be exercised at any time between the date of purchase and the expiration date. Jack Beer Company is an example of an American option.
European options can only be exercised just before expiration. Note that American and European options are not related to geographic location. Long term options (known as LEAPS) are also available on certain stocks.
Understand that call options are more expensive if the strike price is lower. Also, put options are more expensive if the strike price is higher. This is because the lower the strike price, the higher the probability of a call option to be – in the money. The same principle applies to put options too.