Options Trading

When you purchasing an option it gives you the buyer the right, but not the obligation, to buy (if you bought calls) or sell (if you bought puts) a specific amount of an underlying security at a specific price (strike price) within a specified time period (before expiration date). To compare, a futures contract requires both part (the buyer and the seller) to perform under the terms of the futures contract, if an open futures position is not offset before expiration.

The decision whether or not to exercise an option contract is entirely that of the buyer of the options.

An buyer of the options contracts cannot lose more than the amount he or she spent in the options premium and a options buyer cannot receive a margin call. In opposite, options seller may lose much more than the premium he/she received for selling options call, he or she has to maintain margin and could be subject to a margin call.

Below you may see some of the basic points in the options trading:

• When you buy option contracts you receive the right to exercise them.
• As an options buyer, you have the right, but not an obligation, to buy or sell an underlying security at a specified price.
• When you sell options you have obligations to the options buyer.
• There are two types of options:
  • Calls (call options) - give you the right to buy an underlying security.
  • Puts (put options) - give you the right to sell an underlying security.
• Traditionally each option corresponds to 100 shares of an underlying security, however there are mini options that cover smaller number of contracts.
• The price of an option depends on several factors:
  • The current price of the underlying security;
  • The strike price of the option;
  • The amount of time remaining until the option expires;
  • The volatility of an underlying security.
• Strike Price is the price at which an underlying security can be purchased or sold, if an option is to be exercised.
• Expiration Date is the date on which an option expires. It is the 3rd Friday of the expiration month unless it is weekly or quarterly options. Each option has an expiration day. After expiry, you have lost the right to buy or sell the underlying security at the strike price.
• Premium is the price of an option. If an option costs $3 per contract and one contract covers 100 shares of an underlying stock, your total premium is $300 (one contract = 100 shares), plus commission (transaction) costs.
• Please note that options are not available on every stock (i.e., not all stocks are option able).

Investing in Options

Before you start investing into any options, you have to make a decision how much of your money you are not afraid to lose (can safely put at risk). If you are a novice trader to options, it could be recommend to allocate no more than 10% of your portfolio.

Remember:

• With every day goes by, your option loses in time value - they become cheaper.
• Watch out for week-ends and long week-ends. There is no trading but options are losing they value any way as it becomes closer to expiration.
• If an underlying stock's price moves above the strike price of your call option, or if the n underlying stock's drops below the strike price of your put option, you win your bet.
• If an underlying stock does not move the way you thought it would, you may lose the entire premium you paid for your option (if you bought options) or your margin account allocated for options if you sold options short.

If you are an option buyer it is a good strategy do not to wait for an option to expire, but sell it before the expiration date:

Just as important as selecting the right option (strike and expiration) and paying the right price is knowing how and when to leave and take profits. Many option buyers lose money, not because they buy the wrong option contracts, but because in greed they fail to act in time and take profits properly.

When your option contracts starts to be in profit, you must be ready to act. As an example a simple trading strategy for an options buyer could be

• Get ready to close your position and sell your contracts if they drop in price by 10 top 20%. If you lose more than 50% of the premium you paid it is almost impossible to get back as time is running (options loose value with time).
• If an underlying stock makes a big move in your favor, sell your position and take the profit.
• Also take profits or cut losses if you stay in the position more than a week - remember that waiting is trading suicide for an option bueyr.

Cutting your losses is just as important as taking profits.

• It is quite hard part convincing yourself to cut your losses as you will always have some hope even in the worst situation.
• If you do not cut your losses quickly (in time), you will not last as an options player simply because as options buyer you have to guess an underlying stock trend and your prediction should be fulfilled in the shortest possible timeframe.
• If you own an option contracts that has fallen by 50% or more, sell it and close out your position.

Basically, as an options trader you have to know

• When to buy
• When to sell
• Your likely profit target
• At what predetermined target will you take a loss

Points to Remember

• With options you are given the right, not the obligation, to buy or sell a security, at a specific price, for a predetermined period of time.
• Your maximum potential loss is limited to the amount you paid (i.e., the premium) when you buy an option.
• Each option contract corresponds to 100 shares of an underlying security.
• No margin is involved; when buying options is a cash transaction.
• Your maximum potential profit is the amount of the premium you may receive, when you sell (write) an option.
• As options approach expiration they lose time value. During the last 30 days of it's life, an option loses its time value the fastest.
• Options are less liquid than the underlying security.