Options Trading Overview & Strategies

Daniel Penzing
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So What the Heck Are Options Anyway?

Options give speculators the right to buy or sell an underlying asset at a certain price. For example, let’s take a look at a financial Instrument called a Eurodollar. A Eurodollar is a short term US dollar loan that is issued by a bank outside of the United States.

Now that you know a little about a Eurodollar and how it works, let’s also say that you have a large amount of money invested in Eurodollars. You’re really worried about the Eurodollar exchange rate dropping, so you want to be able to transfer your investment in Eurodollars out of your account without disrupting the rest of your portfolio.

What you can do is use a combination of options and a traditional futures transaction in order to insure your investment against losses.

To do so you simply buy a put option , which gives you the right, but not the obligation, to sell your Eurodollars at a certain price. So if the Eurodollar crashes against the US Dollar, you can make your original investment back without ever losing a single penny.

Options give you the ability to choose when you want to invest or hedge against options without involving any risk.

In this article we’ll be taking a look at some of the different types of options and explain how each strategy can help you increase your wealth.

Basic Forms of Options Contracts

Short options contracts are not really a form of options contracts. This is true because a contract must be sold before it can be bought. Instead, options contracts are either bought or sold, because they must eventually expire worthless.

Covered options are contracts where the owner (writer?), of the contract also owns the underlying instrument, or was assigned the contract as part of the underwriting.

Naked options are contracts written by the seller, but not held in any form by the seller, or you may also think of it as selling without one’s shorts on, you get the idea.

Long Call Options Contracts:

These contracts are options written to buy a stated amount of a stock or commodity in the future at a predetermined price (strike price).

Short Put Options Contracts:

These options are written to sell a stated amount of a stock or commodity in the future at a predetermined price (strike price).

Long Put Options Contracts:

These contracts are written to buy a stated amount of a stock or commodity in the future at a predetermined price (strike price).

Short call options contracts are similar to short put options contracts, and vice versa.

Long call options contracts and long put options contracts have many differences.

Positive Theta and Negative Theta:

Theta measures theta decay/gamma decay, and both terms represent the passage of time.

Call Options

When you buy a call option contract, you acquire the right to buy the underlying stock at the strike price, regardless of the current market price. If the stock rises above the strike price, you’re free to buy the share at the lower strike price.

Buying call options has a number of benefits that investors would do well to understand.

Firstly, if the stock price goes down, the price of the call option will go down. This means that you can make a smaller investment to get the right to buy the shares at a later time – the leverage you receive when you buy calls is a huge advantage when things go down.

Secondly, unlike stocks in which you have an obligation to the shareholder, when you buy an option, you have the choice to exercise or not.

The Chicago Board Options Exchange (CBOE) categorizes calls into seven different types based on the period of time you have to take advantage of the rights you’ve acquired. A call option is long-term if you have up to nine months to exercise, while a short-term option must be exercised within a week.

Put Options

If you go through the fund pages at your brokerage you'll see a variety of funds that trade some of the largest companies in the world such as Microsoft (MSFT), Exxon Mobil (XOM), Nokia (NOK) and Johnson & Johnson (JNJ) among others. These companies are the leaders in their industry and have proven their worth.

These companies trade in the equities market.

But, there's one aspect of the equities market that many don't understand – these companies have options on their stocks that are up for sale.

In this article, we're going to look at the basics of the options market as well as the dynamics of put options. Options are an advanced investment and should be explored with careful consideration.

Let's look at the basics of put options….

A put option allows an investor to "sell to open" a contract. It is an option to sell at a designated price on a given date.

An investor may sell or "write" a put option in order to generate income. Put options may be purchased by an investor as a method of insurance against a price decline or to profit from anticipated price declines.

When You Think the Asset Is Going Up in Value — Use a Call Option

Futures markets are where corporations and farmers buy and sell commodities like wheat, soybean and corn before they sell their product to consumers. Futures markets allow producers to ensure they get the right price for their product, and consumers to ensure that they don’t overpay for it.

Futures trading is a zero-sum game, so winners and losers trade off with each other regularly. If you think the price of gold is going up, you might buy a futures contract. If gold prices go down, your futures contract loses value and you have to sell it to someone else at a lower price. The person who bought it from you has now made money because gold went up.

Option Basics

In an option, the buyer has the right to buy or sell an asset, at a future date, at or above a pre-agreed price. Options are characterized by the three common variables:

Type of Option

A call option allows its owner the right to buy an asset; a put option allows its owner the right to sell an asset.

When You Think an Asset Is Going Down in Value — Use a Put Option

If you think an asset is going down in value, you have a couple of different options.

One is to short-sell the asset. Selling short requires you to borrow the stock from somebody else, so a broker will probably want to see a margin account. Brokers also typically charge a fee, since they’re taking on the risk that the price of the stock will go up.

Another option is to purchase a put option. A put option gives you the right to sell a particular security at a predetermined price or strike price. You might purchase a put option if you think the price of a stock or a commodity is going to go down in the future. As long as the price of the stock falls, you make money on the option. If the price of the stock rises, the option is worth nothing.

There are four kinds of put options:

  1. A put option on a stock enables you to sell the stock at a predetermined price. This allows you to profit if the stock price declines.
  2. A put on a commodity such as gold, silver, oil, or grains allows you to sell the commodity at a predetermined price. This gives you the right to make money if the price declines.

Knowing how to trade options is complicated. There are so many factors that affect whether you will succeed or fail in the markets. Among the many factors, traders need to understand the risks they are taking, the premiums they are paying, and whether or not they’re in or out of the money. Furthermore, this process can quickly become a full-time job, so traders need to learn other factors that can assist them when it comes to trading options.

Below we’ve outlined a few of the popular options trading strategies that traders can use.

#1 Covered Calls

Covered calls is a limited risk strategy that involves selling a call option at a strike price held at your choosing to generate premium income at the expense of having to potentially answer for a stock bought at that strike price should the option be exercised before expiration.

Covered call writing requires knowledge on when your stock won’t outperform the market, a thorough knowledge on what the market looks like and the ability to accurately predict ahead of time where a stock’s movements could be.

This guide will show you exactly what covered calls are, how they look, how they work and the best times to employ covered calls as an option trading strategy.

#2 Bullish Spreads

  • Both Bullish Spreads profits can be realized by exiting your position when it has a positive value.
  • They’re two possibilities in Bullish Spreading.

Bullish Vertical Spread:

  1. Buy a lower strike price call.
  2. Sell a higher strike price call.
  3. The outcome is if you merely want to realize a profit at a later date.
  4. Buying the call option with the lower strike means your profit will be limited since the result it is mathematically calculated based on the strike price of the call you have bought.
  5. Selling the call option that has strike price that is higher will result in a bigger profit and lower premium.

Bullish Calendar Spread

  1. Buy a December call option with a strike price that is higher than the current call option
  2. Sell the same type of call option (contract month month) with a strike price that is lower than the original strike price of the call option you have bought.
  3. The outcome is even if the price of the underlying stock increases or decreases, your profit will remain the same.

#3 Bearish Spread

Option trading is a flexible investment strategy used to leverage profits in a variety of market conditions. As you may have guessed, options trading is generally used to magnify the gains of a portfolio. This is done by mitigating risk, buying calls to sell at a higher price, and buying puts when you are bearish on a stock.

Here are a few strategies you should consider if you are basic bearish on the markets.

#4 Collars

The collars are designed to reduce your exposure to significant stock price declines. The collar strategy can also reduce your risk to being stopped out of a long stock position because of a moderate move against you. The most basic collar consists of the following two trades:

The first is a protective put sold against the long stock position. The second is a covered call written on the same stock.

The put is purchased at a premium, which reduces the proceeds available for purchasing the call. The higher the assumed percentage drop in the stock, the greater the amount of premium that has to be paid for the put.

The strategy may appear to be unbalanced. However, this is what keeps the trade from becoming too unbalanced. This also means that the position is a bit more complex than the typical covered call purchase.

The intent of the call is leverage the long stock position, while the put protects against large losses as a result of a price decline in the stock. The collar can be thought of as a variation of the protective put. Instead of buying an at-the-money put, the call is written at the same time for protection against a large decline.

Open interest is the number of option contracts that are still open and not yet settled.

Option contracts for the three closest expirations for the same stock, strike price, and expiration date are considered as the same expiration.

#5 Straddles and Strangles

Summary

There are many kinds of option traders in the world of finance. Some people trade them as a form of speculative trading, for example those who trade as a hobby, those who trade them for a living, as a sideline business, some kind of business venture, or even a massive enterprise.

Others use options as a form of portfolio management. There are some who use options as insurance.

Option trading may be somewhat limited in the asset classes available to trade. For example, stocks, commodities, energy and futures can be traded. But not all. Options are not allowed in all situations; for example options on a security that is not yet public can not be traded.

There are a variety of option trading strategies available, some of which are typical, that is, they are the tried and true ones that are always performed in a typical option trade.

There are other strategies which are new, and not yet widely accepted as being "standard" strategies or approaches. Some of these are still being developed.

There are many ways to trade options, some which are nearly equal to others. Being able to choose the best trade to make is based on knowing the potential of each, and understanding the possible rewards and risks of each.

Even in the same market, the same security, the same price and the same time, there are a variety of factors that effect the price and which type of trade, with what outcome is best.