Options Trading System

Options Trading

There two types of options: puts and calls.

When you trade stocks or Exchange Traded Funds you may buy stocks if you expect it go up in price or you may sell a stock short if you expect it to decline in price. By trading options, if you expect underlying stock to raise in price, you may buy calls or sell short puts. If you expect underlying stock to drop in price, you may buy puts or sell short calls. If you expect underlying stock to move flat (price remain at the same level) you may sell short calls or sell short puts.

A "call option" (also simply referred as "calls") is an option contract that gran the contract holder the right (not the obligation) to buy 100 shares of an underlying security within a certain time frame (before expiration date), at a certain price (at strike price) and who sold you call options has to sell underlying stock to you at this strike price if you make a decision to exercise your right. For this right you pay premium when you buy calls. If the security moves above the strike price (call options are in the money) you are guaranteed underlying stock purchase at the predetermined strike price.

A "put option" (also called as a "put") contract is the opposite of a call contract. A put contact grants you the right (not the obligation) to sell 100 shares of an underlying security before expiration date, at a specific price (the "strike price") and those who sold you put options are obligated to buy from you shares of underlying stock at this strike price. If the security drops below the strike price (put options are in the money) you are guaranteed an underlying stock sale at the predetermined strike price.

Whether you buying call or put options you pay a premium, The less time remains until an option expires, the lower the premium you have to pay for that option. As an example, the premium for an option that expires in a month would be bigger than the premium for an option that expires in a week.

Buying Put Options

As was already mentioned above put options give you the right to sell a stock at a specific price before expiration. You may buy put options when you believe an underlying stock will drop in price. If you want to exercise your right and sell the underlying stock, you have to do it before your put options expire (before expiration date). The investment risk of buying a put contract is limited to the premium you pay or this contract. If your put option expires worthless, the premium you paid will be lost. If the price of the underlying stock decline below the strike price you can make a profit.

If you bought a put options:

• You can let the it expire worthless and lose 100% of paid premium.
• You can exercise your right and sell underlying stock at strike price - make since only if current stock price is lower than the strike price - you buy at the market price and sell at strike price by pocketing the difference as a profit.
• You can sell put options to other traders.

An example to illustrate how put options could be used:

Lets assume that XYZ stock is traded at $50 per share at the current moment and you are buying put options that will expire in three months at a strike price of $46 and you are paying $0.50 premium for a put contract.

If before expiration this stock drops below $46 you may exercise you right and sell XYZ stocks to a trader who sold you put options. Lets say the XYZ stock dropped to $42 per share and you decided to exercise your right. Basically, you are buying this stock at $42 (market price) and selling it right away at $46 which is guaranteed you by a put contract. At the end, you receive $4 - $0.5 (premium) = $3.5 profit by investing only $0.5 (premium) which is 700%

However, if the XYZ stock moves up instead of down and do not drop below strike price before expiration and you do not sell your puts to other traders, your put options will expire worthless. In this case, you lose the premium you paid which is 100% of what you invested.

By buying put options your potential profit is theoretically unlimited, yet you may loose 100% of what you invest (pay for premium).

Buying Call Options

Again, as was already mentioned above, by buying a call options you receive the right to purchase an underlying stock at a predetermined price before expiry date. when you buy calls you are expecting that the underlying security will rise in price within limited time (before expiration). The same as when you buying put options, the maximum risk is 100% of the amount you paid for the options (premium) and the potential profit is theoretically unlimited and depends how far price will run up.

If you bout call options

1. You may let the calls expire worthless and lose 10% of invested money (amount you paid for the premium);
2. You may exercise your right and buy underlying stock at strike price which is only make sense when the underlying stock is traded above the strike price - you buy at strike price and sell at market price by pocketing the difference as profit;
3. You may sell your call to another trader and close your position - depending on the premium you receive, you may lose or win.

An example of buying call options:

The same as with put example above, lets assume a XYZ stock currently trades at $50 and you are buying call contracts with strike price of $52 and an expiration date a month into the future and you are paying $0.50 of premium per contract for the right to buy 100 XYZ shares for $52.

If before your calls expiration date the price of the XYZ stock will go up, lets say to $56 per share you may exercise your right and buy the XYZ stock at $52 from a trader who sold you those call contracts. You my hold this stock or you may sell it right away at $56 per share (market price) and pocket the profit. Basically, in this case of scenario by investing $0.50 (premium) you  gained $56 - $52 - $0.50 = $3.50 which is 700% from the invested amount ($0.50 of premium).

On the other hand, with the same call options, lets say the XYZ stock goes down and will stay below $52 all the time until expiration, it does not make sense for you to exercise your right and buy this stock at $52 when you can by it cheaper at market price. In tis case, you will lose all premium (100$% of your investment) you paid.

Selling Call Options

By selling (writing) a call option, you are selling the right to an option buyer to purchase the underlying stock or index at a particular strike price. Option sellers (writers) have obligations. Selling a call option requires a credit to be deposited. If the option expires worthless, the credit is yours to keep. A trader who sells call options believes that the market will fall.

To make money on a short call, the price of the underlying security must stay below the call's strike price. The profit is limited to the credit received from the sale of the call.

If the price of an underlying security rises above the short call strike price, the option will be assigned to an option holder, who may choose to exercise it. In other words, the option seller must buy the underlying stock or index at the current price and sell it at the call's lower strike price (Current price - strike price = loss). When selling call options, the maximum loss is potentially unlimited, because the underlying stock's upside is theoretically infinite. This is why selling "naked" or unprotected call options (see below) can be a high risk venture.

Selling Covered and Naked Calls:

You may sell two types of call options: you may sell covered calls and you may sell uncovered calls.

If you own a stock shares, you can sell a call option contracts on your stock and receive a premium. This action (when you sell calls on stocks you own) is called writing a "covered call". In case when your stock declines in price, you keep the premium which somehow reduce your loss for that decline. However, when the stock's price moves up, you will have to sell your stock if a trader who bought calls from you decide to exercise the right and buy your stocks - you still keep the premium you previously received.

Uncovered calls (also known as "naked calls") cold be sold in a situation where you do not have (did not previously buy) an underlying stock. However uncovered options are tied by high margin requirements. You still will have to allocate (freeze) certain amount of funds to be able to sell naked calls. You will not be able to use these funds for other investments until you buy back calls or until naked call contracts you sold will expire. You have to understand that your broker must secure his position. These funds are frozen to cover case when call buyers make a decision to exercise his/her right and when you could be pressed to sell him/her underlying stock and since you do not have it you will have to buy it on the market and for that purpose your funds are set aside. theoretically, naked calls are associated with unlimited losses, however, with most brokers, you may not lose more than you allocated for trading uncovered calls as you receive margin call. In reality, you may lose 100% of funds allocated for uncovered call trading. This is sounds almost the same as wit buying calls - in both case you may lose 100% of invested money. However, due to the margin requirements, by selling uncovered calls, traders usually allocate much bigger funds than they would allocate to buy call options.

Option Chart