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Options Trading 101

 

The individual investor will typically include some stocks in their investment portfolio. And whether they are a long term trader or in it for much quicker returns, many investors understand and feel somewhat comfortable with the concepts and techniques of trading stocks.

Options tend to be much less understood - and therefore avoided.

But Options can form an extremely valuable part of your trading strategy as they can provide tremendous returns!

So here I will try and give you some of the fundamental concepts behind trading options.

Options are a contract conferring the right to buy (a call option) or sell (a put option) some underlying instrument, such as a stock or bond, at a predetermined price (the strike price) on or before a preset date (the expiration date).

Options officially expire on the Saturday after the third Friday of the contract's expiration month but because the markets are typically closed on Saturdays, the Friday is commonly used as the expiration date.

A key concept to grasp is that, when you buy an option, you don't actually own the underlying security. You simply own the right to buy (or sell) at a specific point in time. But, of course, the price of the underlying instrument and the time remaing before expiration both affect the value of the option.

So in trading options you have two main ways to make money on them:
- You can hold to maturity and then exercise the option (with the hope that the underlying instrument is then worth more than what you are entitled to buy it at - your "strike price")
- You can sell the option itself prior to expiration (in the hope that the value of the option itself has risen above what you paid for it)

A great many investors do in fact hold until maturity and then exercise the option to trade the underlying asset. Assume the buyer purchased a call option at $3 on a stock with a strike price of $30. (Typically, options contracts are on 100 share lots.) To purchase the stock the total investment is:

($3 + $30) x 100 = $3300 (Ignoring commissions.)

So if, at expiration, the stock is worth more than $33 you've made a profit (You can sell your 100 shares for more than $3300 right away).

Speculating on the actual value of the option itself is the second alternative.
Let's use the same example above.

You bought your options for $3 with a strike price of $30.

If the price of the underlying stock goes above $33 at any time prior to expiration, then naturally more people will want to try and get a hold of that option you own, because they see a high likelihood of making a profit off the underlying security. So, with the increased demand for that option, the value of the option itself will likely go up. So you can sell the option to that higher bidder for a profit.

For example, if the price of the underlying stock rose to, say $35 then the option itself may becoming worth, say $4 on the open market. So you sell your options for $4 and make a nice 33% return. Without ever having owned the underlying stock itself.

Those are the kinds of returns that make options so attractive.

Many brokers offer trading accounts to individual investors that allow options trading and frequently at very competitive commision rates.
It really isn't very difficult to get started.

Options trading is risky, so manage your risk and your assets wisely and only use a small percentage of your overall portfolio for trading options.

But do consider them as an additional component of your investment strategy, as they can yield tremendous returns when traded correctly.

 

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